Using Your Savings on a Mortgage Down Payment

These days, it is surprisingly easy for consumers with below-average credit to buy a home with far less than than the traditional 20% down payment. There are FHA mortgages, which require just 3.5% down. And for those who qualify, VA home loans allow buyers to finance the full price of their home. 

Conventional mortgages with low down payments are also relatively easy to obtain. Fannie Mae and Freddie Mac, which buy mortgages from U.S. lenders, have lowered the requirements for the minimum down payment to 3% for first-time home buyers and low-income borrowers who qualify. In doing so, they have opened the door for banks to compete for cash-strapped home buyers.

While it's possible to buy a home with very little down, whether it’s a good idea is another question. Does it make sense to build up savings until you can put more cash toward closing? And how much of your savings should you invest in housing? Here are some factors to consider. 

Lower Down Payment: Higher Long-Term Costs

Perhaps the first thing to think about with low-down payment loans is that, with few exceptions, they’ll cost you more in the long run. Because you’re financing more of the home price, your interest payments over the life of the loan are going to be considerably higher

For example, if you buy a $200,000 home with 5% down instead of 20%, you’ll pay roughly $35,000 more in interest over the course of a 30-year loan. Obviously, you’ll also be paying more to cover the principal of the loan as well. Using a mortgage calculator is a good resource to budget these costs.

Considering how incredibly low today's interest rates are, this alone might not deter you from buying a home sooner than later. The bigger concern is adding to your expenses the mortgage insurance premiums you’ll typically have to fork over if you buy a house or condo with less than 20% down. The point of these payments is to cover the lender's loss if you default on your loan.

There are two basic types of mortgage insurance. If you take out an FHA loan, private lenders provide the funds for your home purchase, and the government acts as your insurer. If the home is worth less than $625,000, the annual mortgage insurance premium (MIP) is 0.80% or 0.85%, depending on the amount financed. You’ll also have to pay an upfront premium of 1.75%, which amounts to just over $3,000 for a $180,000 loan. 

If you obtain a conventional mortgage, you instead pay something called private mortgage insurance, or PMI. Typically, it costs anywhere from 0.3% and 1.15% per year, although in this case there's no upfront fee.

A Down Payment Compromise

Does the prospect of mortgage insurance mean you should wait until you can put down a full 20% of the home's cost? Not necessarily.

For starters, in some pricier cities, waiting is not always realistic. If you live in a part of the country where even modest homes cost $400,000, you’d have to scrounge up $80,000 before entering the market. And if you reside in an area where buying is less expensive than renting, there might be an extra disincentive to stay on the sidelines until you've saved enough to avoid mortgage insurance.

For some folks, the best option might be to find a middle ground between a minimal down payment and the traditional 20%. For instance, if you take out a FHA loan and put down 10%, your mortgage insurance will be cancelled after 11 years; otherwise, you’ll continue paying it for the entirety of the loan. Can you refinance at a later date to get rid of the insurance? Sure. But there's no guarantee that interest rates will be at or near their historic lows when you do.

In addition, your mortgage insurance premium drops when you make a bigger down payment. When you take out a 15-year mortgage, for example, if you can pay 10% up front the annual payment drops from 0.70% to 0.45%. 

While the details are a little different with PMI, the same logic applies. The greater your down payment, the less you have to pay in premiums. One advantage of PMI, though, is that under federal law you can cancel it once you attain 20% equity in your home.

If the bank keeps your mortgage on their books—that is, it doesn't sell it to an entity like Fannie Mae or Freddie Mac—it may not require insurance at all. However, banks often charge an upfront fee or a higher interest rate if you opt for a low-down-payment loan to help mitigate the risk they're assuming. Even an additional half of one percentage point can cost you several thousand dollars more over a 30-year period. The overall effect is the same: When you put more down, you can borrow for less.            

Risk of Going Underwater

Another pitfall of putting down the bare minimum when you buy a home is that you have less protection if the housing market drops. With only 3% or 4% down, you could easily find yourself owing more to the bank than your house is worth. That's exactly what happened to many homeowners during the 2007-2008 housing collapse.

If you go underwater on your home and unexpectedly lose your job, for instance, you no longer have the option of borrowing against your property to pay expenses or the ability to sell the home without paying a big chunk of money to the lender. While you're not completely protected even if you put down 10% or 15%, you’re giving yourself a much larger buffer should home prices take a turn for the worse.

Keeping A Savings Cushion

Saving for a house is a major life goal. But as you assemble the down payment, be sure you don't leave yourself too short of cash. Not only is it good to have an emergency fund (ideally six months of living costs), you'll also need spare funds for the unexpected expenses that buying a home frequently entails.

Establish a strict budget before you start house hunting, so you know what you can afford to spend. And do what you can to build up your cash reserves as soon as you get settled and finish painting and replacing carpets and cabinets. Also, remember that people say it's good to live in a house a bit before doing renovations that aren't mandatory before you move in.

The Bottom Line

Can low-down-payment loans be a good choice for some homeowners? Absolutely. But calculate the long-term costs of mortgage insurance or the higher interest rate you'll pay to make sure it's worth it.