A house is the most expensive purchase most people will make in their lifetime.
For years, the typical rule of thumb has been that you need to save up to 20% of the purchase price for a down payment. But, soaring home prices and historically low mortgage rates are changing the rules for many potential buyers. “Many, especially first-time homebuyers, may find it difficult to afford a sizable down payment,” according to Jeff Arevalo, a financial counselor with Greenpath Financial Wellness, a national non-profit credit counseling agency.
For homebuyers who can’t come up with a full 20% down payment, a loan — separate from the mortgage itself — might be a tempting way to help cover a down payment. However, experts say that’s a bad idea with big risks. “Taking out a new personal loan to use as a down payment will adversely affect your Debt-To-Income (DTI), which will likely be a red flag to lenders,” warns Arevalo. For most homeowners, there are alternative options that would be better to consider.
What Is a Down Payment and Why Is It Important?
“A down payment is the percentage of the value of a property a homebuyer pays upfront before purchasing,” says Andrina Valdes, COO of Cornerstone Home Lending, Inc. The reason for a down payment is to prove to a lender you have a vested interest in the property and to maintain regular payments. “This upfront payment is used to secure the loan amount a borrower is eligible for,” she explains. That is why most lenders are not comformatble lending out the entire amount of the purchase price.
With the down payment, a buyer can reduce their overall loan-to-value ratio, which represents how much they owe in relation to the value of the home. The 20% down payment was popularized as a rule because it reduces the loan-to-value ratio to 80%, Valdes says.
This loan-to-value ratio is considered a less-risky threshold for mortgage lenders and is the level at which lenders won’t require private mortgage insurance (PMI). PMI adds an extra cost to the borrower, and is designed to protect the lender in case you default on your home loan. PMI can be removed once your home’s loan-to-value ratio decreases.
A bigger down payment can result in better financing options for your mortgage — including helping you get a lower mortgage rate, according Dan Green, an 18-year mortgage industry veteran, founder of mortgage and real estate media publication The Mortgage Reports, and current CEO of mortgage lender Homebuyer.com. The lower your mortgage rate, the less you end up paying in interest costs over the life of your loan. Even a small reduction in rate can lead to savings of thousands of dollars.
How Much is a Typical Down Payment?
Even though there’s a rule of thumb revolving around a 20% down payment, the experts we talked to say that most homebuyers don’t actually save up that much for a down payment. “Having a 20% down payment is great, but not if it will wipe out your savings, leaving you nothing to manage a household or plan for emergencies with,” says Arevalo.
The average down across all borrowers is about 12%, Valdes says, citing data from the National Association of Realtors. Green breaks it down further, mentioning that first-time homebuyers often put down 7% and active-duty military homebuyers often save up 4% for a down payment.
“Down payment sizes don’t correlate with homebuyer performance,” Green says. “Good real estate agents and lenders know that.”
Why Getting a Loan for a Down Payment Is a Bad Idea
Even with lower down payment requirements, it can still be challenging for first-time homebuyers to come up with the necessary money upfront. The median home price for the United States in the third quarter of 2021 was $404,700, according to the St. Louis Federal Reserve. Observing the 20% rule of thumb would require a down payment of a little more than $80,000. Even with a down payment of 3%, you’d need to save up more than $12,000 to buy a home.
Experts warn not to be tempted to take on more debt just to get into a home. “Taking on a new loan payment in addition to the new mortgage payment could cause the household budget to get stretched even more which is never a good idea,” says Arevalo.
Not only do experts advise against this move, it’s not a widely available option anyway. Typically, you can’t get a loan for a down payment,” says Valdes. Most unsecured personal loan lenders forbid their loans from being used for real estate, and most secured loans — like home equity loans or HELOCs — require you to already have a house you can put up as collateral.
Whether your mortgage lender allows you to use a loan for your down payment is another factor to consider. “If you get a down payment loan, it’s not a down payment, it’s a loan,” Green says. “Loans are allowed, but they must be disclosed as part of your mortgage application,” he adds.
Ask your lender about state or local down payment assistance programs. You may be able to qualify for special grants or programs that reduce the down payment cost, especially if you’re a first-time or low-income homebuyer.
Alternative Down Payment Options
The reason many financial experts recommend putting down 20% is because it means avoiding mortgage insurance, securing a better interest rate, paying less total interest on the loan balance, and paying off the loan sooner. But it’s not always necessary, according to Green, Valdes, and Arevalo. “There are many mortgage products that cater to less traditional homebuyers and those often challenged by the older standards,” says Arevalo.
If you don’t have 20%, look into government-backed programs that have lower down payment requirements. An FHA loan only requires 3.5% down, and it’s possible to get a USDA or VA loan without making a down payment at all. Even conventional mortgages can have lower down payments. For example, Fannie Mae’s HomeReady program only requires a 3% down payment. Keep in mind that some of these programs may have restrictions that limit who can qualify.
Down payment assistance programs
Homeowners may be better off looking for other forms of down payment assistance. Valdes suggests checking into state and local down payment assistance programs, particularly those aimed at first-time homebuyers. “Ask your loan officer about programs specific to your area,” she advises.
Green points to a program called Chenoa that makes forgivable home down payment loans as part of home buying assistance. “FHA loans allow for second mortgages like the Chenoa program,” he says.
Lastly, some mortgage programs, like FHA loans, also allow down payments to be gifted, says Valdes. If you have friends or family members willing to help out, they may be able to help fund your down payment. You can also use gifted funds from loved ones to cover closing costs, she adds.
It’s important to look at the requirements to qualify for these programs. USDA loans have income and location restrictions, and VA loans are only available to service members, veterans, and eligible surviving spouses.
How to Save for a Down Payment
If you don’t qualify for any assistance programs, it is better to wait and save over taking out a loan to cover the down payment. Valdes has some tips for finding the extra cash to put toward buying a home:
- Prequalify to find out how much house you can afford and an exact down payment amount you can start saving for.
- Ask your loan officer about which no-down-payment loans you may be eligible for.
- Allocate your tax refund toward a down payment on a new house.
- Cut out extra services, including the gym, Hulu, other subscription services, and set that money aside for the future.
- Consider getting into a starter home or condo now, so that you can build equity and trade up later.
Don’t spend too much time trying to hit what might be a moving target when you try to save up for a set percentage for your down payment, Green suggests. Rather than getting hung up on a specific percentage, whether that’s 20%, 10%, or 3%, it might make more sense to set aside as much as you can and then look into down payment loan and assistance programs. If you have good credit and reliable income, Green points out, you can probably find a lender willing to work with you and help you find a program that can help you meet your homeownership goals.