One of the main concerns when buying a home is how big your down payment should be or how much your home loan will require. In fact, there is no correct answer, which will surely confuse first-time home buyers.
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Standard wisdom has been that homebuyers should put down 20% for years, but that’s not really some type of industry authorization – a common metric for lenders and real estate agents. While some real estate experts may tell you that you need to put down 20% (which may be appropriate in many cases), it's not that you can't buy a home legally unless you're going to have so much cash pony.
But, everything from saving money to closing costs remains: How much do you actually need? Let's explore.
While there are no “rules” to pay a down payment for a home, the minimum requirements for certain loan types. Individual lenders are free to claim any down payment for their desired mortgage plan. Here are some considerations:
If you are eligible for a VA or USDA loan due to your affiliation with the military, you can reduce your loan by 0%.
FHA loans are typically expanded to loans with lower credit scores that can be paid down payments as low as 3.5%.
Most traditional loans, including adjustable interest rate loans, need to drop at least 5%, although some lenders may drop to 3% to reduce down payments.
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The most common reason why 20% of 20% is often recommended is that it allows you to avoid using private mortgage insurance, commonly known as PMI. Statistically speaking, private mortgage insurance helps protect lenders from defaults, and a smaller down payment may make defaults more likely.
PMI will increase your mortgage cost considerably, typically 0.5% to 1.5% of the loan amount per year. In a $300,000 loan, this means your PMI will add between $125 and $375 per month.
Not only is this enough to keep you from housing, but it is basically a waste of your monthly payments. While your mortgage itself will actually help you build equity in your home, your PMI is just lined up in the insurance company’s pocket and possibly higher interest rates.
The reason many people think you put 20% at home is that it will most likely stop you from “turning upside down” on your loan, or owe more value to your home. For example, if you put down 5% of your home value, the home value drops by 10% and your home value will be smaller than the size of your mortgage. But if you put 20% down 20%, then your home still has an interest, which is a better long-term financial plan.
While putting 20% on a home is considered a conservative option, there are some potential drawbacks. First, saving enough down payment can take a long time to pay 20%. For example, if you are looking at a $400,000 home, you need to save $80,000 in down payment.
Depending on your income and saving habits, this can take years. If you only put down 5% of your money, you can just come up with $20,000. This may get you into your home soon, keep you away from rent, and potentially benefit from the home price appreciation a few years ago.
Another drawback of investing so much money is that it is essentially "lost". While your down payment will become fairness in your home, it’s actually difficult to use the money. To withdraw it, you either have to sell the home, or take out some type of home equity loan or line of credit, or withdraw cash through refinancing.
All of these options take time, and some may reduce or damage your equity in your home. If you put down a small amount of money, you can use the extra money to other investments, such as the stock market, while still owning a home.
The first thing you should realize is how many "wrong" answers you put down on the house. Everyone has different financial situations and goals, so the decision you make should be the best for you, not some hypothetical home buyer.
Ideally, if you can put down 20%, that is the most conservative option, avoiding PMI. But you don't need to let go of 20%, and in some cases, your financial situation may be better if you don't. Consulting a financial advisor is always a good idea to help you determine the best option for you and your new home.
John Csiszar contributed to the coverage of this story.
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This article originally appeared on gobankingrates.com: Homebuying 101: You may misunderstand the drop in payments