December 5, 2017
December 5, 2017
If you’re a first-time home buyer, you probably expect to make a minimum down payment when you buy a home. But there are pros and cons of making a minimum down payment, and you should be aware of them before you make your purchase.
One of the specific purposes for minimum down payment purchases is to enable people to buy homes sooner than they might otherwise.
If you have to save enough to make a down payment equal to 20% of the purchase price of a home in your area, it might take several years. For example, if the typical purchase price in your area is $250,000, you would need to save $50,000 for the down payment.
If you earn a typical income, of say $60,000, it could take you four or five years to save $50,000.
Not only will this make it take much longer to purchase a home, but house prices may be significantly higher after four or five years. The $250,000 home you are saving up to buy, is now selling for over $300,000. That will raise the amount of down payment that you need, but it will also increase your monthly payment.
In the meantime, you will have missed out on participating in the price appreciation, as well as the tax benefits that homeownership provides.
In today’s economy, it’s very difficult to save a large amount of money. If you decide to make a down payment of 20% or more, your only alternative may be to get a gift from a family member.
While that’s a common situation, it’s not without issues.
First and foremost is the possibility that you have no family members who can provide the needed gift. Second is that a family member may provide a gift, but seriously impair their own financial situation in the process.
There’s also the sense of obligation that comes with accepting a gift. Family relationships have been known to change with the exchange of a large amount of money. And even though the money is a gift, there’s sometimes the expectation of repayment at a later date.
Making a minimum down payment enables you to avoid that entire situation.
For first-time homebuyers, the first years of homeownership can represent a financial squeeze. You typically need to become accustomed to a higher monthly house payment than what you had known before. You may even experience higher utility payments since a home is larger than an apartment.
At the same time, you’re also spending money “feathering your nest.” You may be purchasing additional furniture, as well as appointments, like carpeting and window treatments. There may even be certain necessary repairs that you’ll have to make and pay for.
As you go through this process, having some extra money after the closing would be a definite benefit. If you make a minimum payment and still have savings left, you’ll have the cash necessary to work through the adjustment.
Whenever you make a down payment of less than 20% of the purchase price of a home, you are required to pay private mortgage insurance (PMI). The problem with PMI is that it increases your monthly payment. What’s more, the increased payment doesn’t reduce your loan principal balance. It’s simply a monthly expense that’s gone after it’s paid.
For example, if you make a 5% down payment, with a $200,000 mortgage, PMI will increase your monthly payment by $145.
You’ll have to continue making that additional monthly payment until your loan balance is paid down to less than 80% of the value of your home. In the process, you may pay thousands of dollars for the insurance.
Setting PMI aside for a moment, let’s say that you’re purchasing a house for $200,000. If you make a 20% down payment, your mortgage balance will be $160,000. On a 30-year fixed rate mortgage at 4%, your monthly payment will be $754.
If you make a 5% down payment on the same house, your mortgage balance will be $190,000. On a 30-year fixed rate mortgage at 4%, your monthly payment will be $907.
This means that your monthly payment will be $153 a month higher if you make a minimum down payment, instead of 20%. That translates into $1,836 per year. And on a 30-year basis, it’s a difference of more than $55,000.
You will almost certainly refinance the original mortgage, which will reduce the long-term higher cost of the lower down payment mortgage. But the extra cost will still be there in the early years of homeownership.
Since mortgages are underwritten based on the risk represented by each loan, making a minimum down payment automatically makes your mortgage more risky to the lender.
The higher risk associated with the lower down payment will cause the lender to impose more restrictive underwriting guidelines. For example, the lender will most likely insist that you have good or excellent credit. They will also require that you have cash reserves equal to several months of the new house payment after closing.
Perhaps more importantly, they will be less forgiving regarding debt-to-income ratio (DTI). That’s the total of your new house payment and recurring non-housing debt payments, divided by your stable monthly income.
Where a lender might accept a DTI of 40% on a loan with a 20% down payment, they may restrict you to 36% on a minimum down payment loan.
If you have good or excellent credit, and your DTI is well within guidelines, it will be easier to make a minimum down payment. But if you’re weak in either area, a minimum down payment can be more complicated to qualify for.
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