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Do you need to put 20 percent down on a house?

sold_houseUpdated by Richard Barrington

When you buy a home, some financial experts recommend making the largest down payment possible, while others suggest financing as much of your purchase as possible. The right answer depends on market conditions and your circumstances.

"It's important to ask the right questions about how various down payment amounts will affect your mortgage insurance and mortgage payments," says Keith Gumbinger, vice president of HSH.com. "You need to figure out if it's worth begging your parents for a certain amount of cash."

Before you resort to the Bank of Mom and Dad for down payment assistance, whether that be gift money or a loan, it might help to know the pros and cons of a large down payment, and some possibilities for raising this up-front money.

What is the average down payment on a house?

While 20 percent of the purchase price is a traditional target for a house down payment, there are programs for both FHA and conventional mortgages (those backed by Fannie Mae and Freddie Mac) that allow for much smaller down payments.

In fact, conventional mortgages can have down payments as low as 3 percent, though people generally make a larger down payment for a variety of reasons. The typical size of a down payment varies greatly depending on the local real estate market.

According to a survey by Realtor.com, the lowest average down payment is just 6.8 percent in Virginia Beach, VA. At the other end of the spectrum, home buyers in San Jose, CA plunk down an average of 23.9 percent when buying a home.

Why such wide differences? In large part, it is because home prices in expensive markets such as San Jose often exceed the mortgage limits for low down payment programs. In those markets, this compounds the difficulty of saving for a down payment -- not only are home prices generally higher, but a greater percentage of the price must be paid upfront.

Fortunately, in many areas of the country home buyers have some flexibility as to the size of their down payments. If you have a choice, is it better to put a large down payment on a house, or save your current resources by borrowing as much as possible?

Is it better to put a large down payment on a house?

According to Fannie Mae, the biggest obstacle to first-time homebuyers is coming up with money for a down payment and closing costs. So, doesn't it make sense to lower this hurdle as much as possible by minimizing the down payment?

Maybe, but there are also several benefits to a larger down payment.

Why you should put 20 down on a house

Here are six advantages of making a house down payment of 20 percent or more.

1. Smaller mortgage loan balance. A larger down payment means starting out with a smaller loan balance, which has a few advantages. One of these is that it creates a cushion to preserve equity in your home even if market values decline. That could make the difference in being able to refinance or sell your home in the years ahead.

2. Lower mortgage rates. One way mortgage lenders measure risk is through the loan-to-value (LTV) ratio. The smaller your down payment, the higher your LTV ratio is and the riskier your loan appears in the eyes of lenders. Lenders tend to compensate for making riskier loans by charging higher interest rates, so you might be able to qualify for a better rate if you lower your LTV ratio by putting more money down.

3. Less interest expense. The above two effects of a larger down payment -- making loan balances smaller and mortgage rates lower -- combine to reduce the total interest you pay over the life of a loan. A mortgage calculator can show you the total interest you would have to pay so you can see how much a lower down payment would save you in the long run.

For example:
Pay extra $50,000 up front. Doubling a down payment on a $500,000 loan from 10 percent to 20 percent means paying an extra $50,000 up front.

Save more than $96,000 long-term. On a 5 percent 30-year mortgage, that higher down payment means paying $96,627.89 less over the life of the loan -- $50,000 in less principal repayment plus a total of $46,627.89 less interest.

4. Reduced mortgage insurance premiums. Mortgage insurance covers the risk of borrowers not repaying their loans. Since this risk is greater for mortgage loans with higher LTV ratios, the size of your down payment can affect how much mortgage insurance you have to pay, how long you have to pay it, and the size of your premiums.

5. Positive budgeting experience. Saving for a down payment may be challenging, but it will also allow you to practice the budget habits you will need in order to make your ongoing mortgage payments. Too many home owners learn only once they take on those monthly mortgage payments just how much of a strain they put on a budget. Think of saving for a down payment as a trial run to see how much room there really is in your mortgage.

6. More manageable monthly payments. A number of the above factors - reducing your loan balance, mortgage rate and mortgage insurance premium - can contribute to making your monthly payments lower. This is another good use for a mortgage calculator - it can show you how much less of a burden your monthly payments will be if you start off with a larger down payment.

Disadvantages of a large down payment

While there are good reasons to consider a large down payment, you should also be aware of four potential drawbacks.

1. Longer time to enter the market. The months or years spent saving for a large down payment can delay your readiness to buy a house. This means paying rent for that extra time, and if housing prices are rising rapidly in your area, it could result in prices getting away from you.

2. Less short-term flexibility. Cutting savings to the bone to increase your down payment can backfire, since owning a home often means dealing with unexpected expenses. As Joseph Montanaro, a financial planner with USAA Enterprise Affairs explained to HSH.com, it's critical for homeowners to have a healthy emergency fund in place to deal with home maintenance and repairs." A smaller down payment could allow you to maintain an emergency fund, pay down high-interest debt, or utilize the funds for other goals. However, making a smaller down payment should not be an approach to buy a home you can't afford."

3. Interference with investments or retirement saving. Money you accumulate for a down payment can take away from money you put toward other goals. For example, you may have to cash in some long-term investments to come up with a down payment, or putting aside money for a home might restrict your retirement or college savings. Whenever you look at the benefits of a large down payment, you should also take into account the opportunity cost of diverting that money from other things.

4. Benefits take a while to add up. Many of the benefits of a large down payment reward you more in the long-term than in the short-term, which may not be much use to you if you don't plan to stay in the house long. Scott Davis, a Washington DC-area mortgage manager advised HSH.com that "your first question should be how long you intend to live in the house, because if you plan to leave in a few years it may not make sense to put in a lot of extra cash."

The pros and cons of a large down payment encompass a number of factors, including your local real estate market, your financial situation and your long-term goals. Once you understand whether a large down payment makes sense for you, the next step is to figure out how to come up with the money you need.

5 Ways to get a down payment for a house

Here are some options for raising the down payment amount you need:

  1. Personal loan for down payment on a house. While it is possible to take on a personal loan in addition to your mortgage to come up with a down payment, there are several problems with this. Some mortgage programs restrict you from borrowing for a down payment, and if you do it is likely to impact both your debt-to-income ratio and your credit score. Those are major factors in whether you qualify for a mortgage loan, and if so, what interest rate you get. Speaking of interest rates, the rate you get on a personal loan is likely to be much higher than your mortgage loan rate.
  2. Down payment assistance. This is where the Bank of Mom and Dad may come in. There are also a variety of state-sponsored home buyer programs that may contribute toward your down payment.
  3. Sale of assets. You may have some investments you can access, some valuable jewelry or collectibles just gathering dust or perhaps it's time to sell off something like a boat or a second car to raise money for a down payment. This is a case of weighing the long-term benefit of holding onto the asset against the benefit of getting into a home sooner and/or with a larger down payment.
  4. 401(k) loan. It is possible to borrow from your 401(k) plan, in some cases to fund a larger down payment. Because this allows you to access 401(k) money without incurring a tax penalty, some people view it as a cost-free source of money for a down payment -- after all, what could be the harm in borrowing from yourself? Well, tapping into your retirement assets even on a temporary basis is likely to slow your ability to build your nest egg, and worse, some 401(k) plans require you to pay back the loan immediately if you leave your employer.
  5. Budgeted savings. Setting a little extra aside from your household budget month-after-month is the slow-and-steady way of raising money for a down payment. It's great practice for the extra financial burden a mortgage payment is likely to represent. However, in fast-rising real estate markets this slow-and-steady approach might cause you to miss an opportunity.

Be sure to consider both the short- and long-term ramifications before making the decision to commit a large down payment or even buy a home with cash. Like many financial decisions, the size of your down payment is a trade-off between immediate and long-term benefits.

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