2021 was the year we saw everything get more expensive. From gas to grapes, inflation, supply chain issues, and overconsumption contributed to a short supply of almost everything. And nowhere was that seen more for people looking to buy a home.
A combination of record low interest rates and limited supply forced home prices up by over 21% in 2021 alone. A major consideration for home buyers was how much down payment do you need to buy a house in this volatile market?
While the market has changed, down payment requirements remain the same. So here’s everything you need to know about down payment requirements and best practices.
What is a Down Payment?
A down payment is a lump sum deposited with a lender to lower the amount of the loan you have to take out to purchase a property. The lower your downpayment the less money you have to save and part with upfront. The larger your down payment, the more equity (or ownership) you have in your investment.
Minimum Down Payment Requirements
Most lenders require a minimum down payment of 3.5% for a conventional or Federal Housing Administration (FHA) insured mortgage. However, there are many programs that offer low or no down payment options.
Many states and municipalities offer down payment assistance (DPA) programs to help first-time homebuyers get into their dream home. These programs can provide financial assistance in the form of grants, forgivable loans, or tax credits. Eligibility requirements vary by program, but most require that you be a first-time buyer and/or meet income restrictions.
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Do You Need A 20% Down Payment On A House?
Traditional personal finance advice encourages a down payment of at least 20% of the purchase price of your home. Fortunately, this isn't the case today. The average homebuyer today actually puts only 6% down on their home.
The recommendation comes from lending requirements of the early 1900s. Until 1956 you couldn’t purchase a house unless you put a minimum 20% down payment. This allowed the banks to sell a house at a discount when someone defaulted on their loan and not lose much money. As house prices began to rise after World War II, banks realized that not everyone could afford 20% down. Fannie Mae also started buying up mortgages from lenders and packaging them into mortgage-backed securities making them less of a risk to banks. Thus the 20% down payment rule left and Private Mortgage Insurance (PMI) was born.
Is PMI a Waste of Money?
Today, because lenders are often insured against loss by private companies or subsidized by the government, they have little incentive to require a high minimum down payment. If you have less than 20% to put down on a property, you will simply need to purchase mortgage insurance. This protects the lender in case you default on your loan in the absence of 20% equity.
The average cost of private mortgage insurance for a conventional home loan ranges from 0.58% to 1.86% of the original loan amount. Some people believe PMI is a waste of money and still recommend putting 20% down to avoid it. But if properties in your area are appreciating at a rate higher than PMI you may be better off buying a home now with a smaller down payment and benefitting from the appreciation rather than waiting to save 20% for a down payment.
Your Loan-to-Value Ratio
The Loan-to-Value (LTV) ratio is the percentage of your loan amount compared to the value of the property. So, for example, if you take out a $200,000 mortgage on a home worth $225,000, your LTV would be 90%.
Generally, the lower your LTV ratio, the better interest rate you will receive from a lender. There are a number of ways to increase your LTV without saving a larger down payment. You can choose a less expensive property, borrow from family or friends, or use gift funds from relatives. Some lenders may also allow you to use certain assets as collateral for a loan against the down payment.
You can easily remove PMI from your loan by calling your lender once your loan reaches 80% or less of the original value. If your home has appreciated quickly you can refinance to a new mortgage and use your home’s current value to calculate your 80% or less LTV.
Benefits of a Larger Down Payment
While you may not need to put 20% down there are several benefits to putting more money down on a home.
- You'll pay less in interest over the life of your loan.
- You may be able to avoid mortgage insurance premiums sooner.
- A larger down payment can give you more bargaining power with sellers, as they will know that you're not as reliant on getting a mortgage loan.
- It may help you qualify for a loan if your debt-to-income ratio is high.
- You'll have more equity in your home from the beginning, which could come in handy if housing values decline in the future.
- It can be a signal to lenders that you're a responsible borrower who is less likely to default on your loan.
A larger downpayment is generally preferable but of course, there are also some drawbacks to putting more money down on a home.
First, you may have less money available for emergencies or other investments which could lead to debt. It could also take longer to save up for a larger down payment. This is especially bad if home prices increase at a rate faster than you’re saving.
How Much Should You Put Down on a House?
So, how much down payment do you need? The answer depends on a variety of factors, including your credit score, the price of the home you're buying, and the type of loan you're using.
You should aim to spend no more than 30% of your take-home pay every month on your housing. To figure out what that number is you’ll need to create a budget and track your income. Determine how much you can save and how long it’ll take you to save it then determine a budget for your home purchase.
Remember that the bank will qualify you for a mortgage payment much higher than 30% of your pay so be careful to not be tempted by houses you may qualify for but could make you “house poor” month-to-month.
Can You Buy A House Without A Down Payment?
There are several programs that allow you to buy a house without putting any money down. You will still have to pay closing costs but these programs help buyers get into homes much earlier.
USDA loans offer 100% financing for buyers in rural and suburban communities. VA loans offer 100% financing for members of the U.S. military, veterans, and their surviving spouses. You can also ask the seller to cover closing costs which may not lower your down payment but it can lessen the burden and make it feel like a lower down payment.
The catch is, of course, that your monthly payment will be much higher than if you had put some money down on the property. For one thing, you'll have to pay private mortgage insurance (PMI), which usually costs between $50 and $100 per month for every $100,000 financed. Once your equity in the property reaches 20%, your PMI should drop off—but it could take several years before that happens.
The Bottom Line
Owning your home is foundational to building wealth. While it's important to consider the down payment, don't let it keep you from buying the home you want. With careful budgeting and some creativity, you can come up with the cash you need.