Throughout the home buying process, you are going to hear many terms that you may not be familiar with, like “comparative market analysis” and “debt-to-income ratio.”
Fortunately, you don’t need to know all of these terms to purchase a home. But there are a few that you should be keenly aware of, even before you talk to a lender or realtor. Here we’ll discuss one in great detail: the down payment.
What is a Down Payment?
A down payment is a payment made in cash at the onset of the purchase of an expensive good or service. It represents a percentage of the purchase price and is not refundable if the deal fell through because of the purchaser.
That said, a down payment is not the whole amount that will need to be settled with your title company at the time of your closing. In fact, you may elect to pay closing costs too.
Down Payment VS. Closing Costs
It’s no secret that there are many hands in the pot when it comes to real estate transactions. At the time of closing, all of these hands want to get paid for the services they provided throughout the home-buying process.
Sometimes you can have your closing costs wrapped into your loan—known as “cash due at closing.” Other times you can negotiate with the seller to pay some or all of the costs for you. But more often than not, closing costs are going to fall on your plate. It is worth noting that the seller and buyer will each have their own closing costs to be paid as well.
What is Included in Closing Costs?
You don’t want to show up on the day of your closing without knowing all the costs you are responsible for. Fortunately, lenders are required to give you a closing disclosure document at least three days before your scheduled closing.
Making sense of closing disclosures
The closing disclosure is a breakdown of every cost included in your home purchase. Some fees will be going to the county in which the home is located or to the closing attorney (or title company) that is preparing the transaction. The disclosure will also show any services the lender required you to get, such as an appraisal or termite inspection.
You want to go through these disclosures thoroughly and ensure that the lender has not made any mistakes. This is your best chance to get any necessary changes made before the closing date.
You should verify that all personal information is correct and that any arrangements made between you and the seller—or between you and the financial institution doing the lending—are shown on this report. For example, if the seller said they would credit you $1,500 for repairs that need to be made, that should be shown on the third page of the report as a closing cost to the seller.
It is highly recommended that you keep track of any expenses you incur during the home-buying process. Keeping records makes it easier to verify that all charges incurred on your closing disclosures are accurate.
You also want to make sure that you aren’t getting charged for something you have already paid for.
Estimating Closing Costs
Most lenders can estimate closing costs for a home, given its price and location. But you can always refer to a closing costs calculator if you want.
Specific costs that go into closing can include origination fees for the loan, application fees, underwriting fees, appraisal and inspection fees, property taxes, and insurance.
How to Pay Your Down Payment
The most common ways of paying a down payment at closing are checks, money orders, or wire transfers. Some people use a HELOC (home equity line of credit) or a 401(k), and even credit cards, though these aren’t recommended.
Unfortunately, not all of us will be able to save enough money to put toward the down payment on a new home. There are some options, though.
Can a down payment be a gift?
Yes, it can! However, there are some issues with monetary gifts that you will want to be aware of, even though they mainly apply to the gifter, not the giftee.
Just getting accused of committing mortgage fraud would be bad, but actually committing it would be worse. You must pay attention to what’s legal and what’s not when it comes to receiving a down payment as a gift.
There are more requirements, but you will need to have a signed letter that confirms your relationship with the person who is gifting you the down payment, stating that it is, in fact, a gift. At no point are you allowed to repay the gift—that would be regarded as a loan and may be considered mortgage fraud.
Another thing to be aware of is moving the money around well ahead of time. This is something that your lender will probably make sure happens, but the banks want to be able to trace the money that is being gifted to you for your down payment. They do this to ensure that it is coming from a legitimate source.
In most circumstances, you can receive a gift for the full amount of your down payment.
Is there a tax benefit to the down payment gift-giver?
No, not really. As a matter of fact, the gift-giver could incur an extra gift tax from the IRS if they were to go over the annual exclusion amount for a gift.
In short, as long as you don’t gift more than $15,000 as an individual, or $30,000 as a joint tax-filing couple, you will not be hit with a gift tax.
How much is the gift tax?
This is where it can get a little convoluted. There is another piece of the puzzle called the lifetime gift tax exemption. This is a number, currently just over $11.5 million, that you can gift up to in your lifetime.
The lifetime exemption doesn’t come into play as long as you stay under the annual gift exemption amount. If you were to exceed the annual allowable gift amount, the overage would be deducted from your lifetime gift total, leaving you with less than you can gift without being taxed on it.
Crowdsourcing as another alternative
With platforms like Kickstarter and Indiegogo becoming so popular, it is no wonder that crowdsourcing has made its way into the home purchasing space. Some popular sites to crowdsource your down payment are HomeFundIt and Feather The Nest.
What is Down Payment Assistance?
Believe it or not, there are programs out there designed to help you put a payment down on a home you would like to purchase. This is called Down Payment Assistance.
Each state has its own separate entities that take care of the down payment assistance programs. Less populated states have fewer programs, while other states that are far more populated have many more programs.
How do I qualify for down payment assistance?
The exact rules for how to qualify depend on the state you live in and the program you’re applying for. Some programs cater to specific groups, such as first responders, nurses, or veterans. Other programs care only about how much money you bring in annually.
To find out if you qualify, you have to do some research into the programs offered by your state.
Do I have to be a first-time homebuyer to qualify for down payment assistance?
You do have to be a first-time homebuyer to qualify for most of the programs. Fortunately, according to the Department of Housing and Urban Development (HUD), being a first-time home buyer just means that you haven’t had any ownership in a primary residence within the last three years.
If you owned a home that you sold five years ago, for example, and have been renting ever since, congratulations! You would be classified as a first-time home buyer and qualify for many down payment assistance programs.
How Much Should Your Down Payment Be?
On average, home buyers are putting down anywhere from 10%-20% on a home. Down payments, however, have multiple factors involved. For instance, if there are a ton of offers made on a home, then a higher down payment might make your offer look more competitive. You also may have to raise your down payment as the price of a home rises.
You should also consider private mortgage insurance (PMI). Lenders require PMI when you don’t have more than 20% equity in a home. If your down payment is less than 20%, you’ll need to pay for this.
How much does my down payment need to be?
The answer to this question, again, is not cut and dried. How much you need to put down on a home depends on the loan product that you are trying to use. VA loans or USDA home loans offer no-money-down options. If you don’t qualify for one of those loans, a down payment on an FHA loan, which the Federal Housing Authority backs, can be as little as 3.5%.
Why and how your credit score factors in
Your credit score will affect the interest rate that you will be approved for, but it might also affect how much you need to put down.
If you are applying for an FHA loan and have a score over 580, you should be able to qualify with only a 3.5% down payment. However, if your score is under 580 and you can qualify for the loan, you will have to put down 10%.
Pros of Making a Bigger Down Payment
Pay less for your house
Interest on your mortgage is simple interest, meaning that your interest is not compounded, or cannot gain interest on itself. Still, by making a larger down payment, you effectively reduce the amount you will ultimately pay for the home.
The following example uses and shows how putting different amounts down can lower your overall payment for your home, assuming a $250,000 loan. In the example below, we use a 30-year fixed-rate loan of 5%.
Down payment interest savings example
Taking out a loan for $250,000 would leave you with a mortgage-only payment of $1,342 per month. Over the life of that loan, if you paid your mortgage on time and put nothing else toward the loan’s principal, you would end up paying $483,139.
We will now run the numbers with a 5%, 10%, and 20% down payment.
Depending on which down payment you make, you would save $24,157, $48,313, or $96,627, respectively. That is almost a 100% return on your investment.
Lower your interest rate
Lenders are more likely to give you a better interest rate when you put down 20% compared to 5%.
Reduce your monthly mortgage payment
It doesn’t take a math whiz to realize that you will be required to pay less each month by lowering the total loan amount and paying less interest. When comparing a 5% and 20% down payment on a $200,000 home, you can easily see that the higher down payment lowers your monthly mortgage significantly.
Higher chance of your offer being accepted
This one may be a little more mythical than numerical, but it still carries weight. When faced with the decision between two offers on their home, where the only difference is the amount of the down payment, a seller is much more likely to choose the offer with the higher down payment. This is because the buyer putting down more looks more credible in the seller’s eyes and is less likely to have problems throughout the loan process.
This is even more true when looking to purchase a home in a competitive market at a competitive price point.
Pros of Making a Smaller Down Payment
Get into a home faster
Saving is difficult. It can be very slow-going and painful.
When you are trying to purchase a home, the last thing you want to do is wait years and years to build up enough in a savings account for a large down payment. By putting less down, you will be able to get into a home more quickly.
Leave more in savings as an emergency fund
All things being equal, by putting less money toward your down payment, you will be able to keep more in your savings account. This means that if anything were to happen to your income stream, you wouldn’t be as at-risk of defaulting on your home loan.
Down Payment Size Considerations
There are a few main questions to ask yourself when deciding your down payment amount.
How much do you have saved?
How much will you have left after making the down payment? The last thing that you would want is to save up all this money, get settled into your home, and then have an emergency happen that you couldn’t afford to pay for because all of your money is tied up in your home.
Putting 20% down is probably not the best choice for you if it will leave you with little to nothing in your savings account afterward. Bite the bullet of taking on mortgage insurance and work toward getting to that 20% equity mark (in which case you’d be let off the hook for the mortgage insurance).
How long are you planning to live in the home?
The longer you plan on staying in the home, the more valuable each dollar of down payment becomes.
If you plan on living in the home for less than 10 years, then making a larger down payment may not be the best choice.
Are you an active investor?
With low mortgage interest rates, your down payment does not gain the greatest return on its money. That said, it is a guaranteed return on your money (whatever interest rate you get) that you can’t get almost anywhere else.
What size monthly mortgage payment can you support?
If you have a lot of money saved up for a down payment, but you don’t have enough each month to support a higher mortgage payment, then putting more of that savings down is a good idea. This is especially true if putting more down is going to save you from mortgage insurance.
As you can see, answering the question as to how much you should put down on a home is not the easiest thing to do. There are many variables that you need to account for to make the best decision for your specific needs. Hopefully, you now know at least a little more about down payments (and closing costs!) and can make a more informed decision.
If this is something that you are struggling with, I would advise that you seek out the opinion of a financial advisor or counselor who can help you navigate the process.