3% Down? Why Small Down Payment Mortgages Could Be a Bad Idea

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Updated on Monday, January 29, 2018

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For prospective homeowners, the idea of saving up for a 20% down payment — usually tens of thousands of dollars — can often be paralyzing. As a result, small or no down payment mortgages are extremely attractive.

But as usual, taking a shortcut financially can come back to bite you. Mortgage loans that have a low-minimum down payment usually require extra fees or insurance to make it worth the lender’s while.

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To determine whether a small down payment mortgage is right for you, it’s important that you know what you’re getting yourself into and how much it can cost you in the end.

Mortgages that require a small down payment

Small down payment mortgages are attractive primarily because they allow people to buy a home sooner than if they had to put a full 20% down.

This can be appealing for personal reasons since owning a house often makes it feel more like home. And it can occasionally be attractive for financial reasons, potentially saving you money compared with renting, particularly if you stay in the house for an extended period of time.

Additionally, there are several home loan programs that offer small or no down payment mortgages to those who qualify:

Veterans Affairs (VA) loans

These loans are insured by the U.S. Department of Veterans Affairs for certain veterans, service members, spouses and other eligible beneficiaries.

They don’t require a down payment or mortgage insurance but do charge a one-time funding fee of 0.5% to 3.3%, depending on the type of loan, the size of the down payment and the nature of your military service.

U.S. Department of Agriculture (USDA) loans

The U.S. Department of Agriculture insures home loans for low- to moderate-income homebuyers in eligible rural areas.

Like VA loans, there is no down payment for a USDA loan. But there is an upfront fee of 1% and an ongoing annual fee of 0.35%, both of which apply to purchases and refinances.

Federal Housing Administration (FHA) loans

Insured by the U.S. Department of Housing and Urban Development (HUD), borrowers can get an FHA loan with a down payment as low as 3.5%.

Additional fees include an upfront mortgage insurance premium of 1.75% and an annual mortgage insurance premium of 0.45% to 1.05%, depending on the type, size and length of the loan and the size of the down payment.

Conventional loans

Some mortgage lenders offer small down payment mortgages — as little as 3% down payment — to borrowers who qualify.

These loans, however, aren’t insured by a government agency, so the lender will require private mortgage insurance (PMI). The cost of PMI varies but is often between 0.5% and 1% of the loan amount. You can typically request to have your PMI dropped once you have at least 20% equity in the home.

Learn more: Planning your down payment

The benefits of small down payment mortgages

These small and no-down payment mortgage options are designed for those with low- to moderate-incomes who either don’t have enough cash on hand for a large down payment or find it difficult to qualify for a conventional mortgage for credit reasons.

For example, you can get an FHA loan with a 3.5% down payment with a credit score as low as 580. VA loans technically don’t have any minimum credit score requirement, although you may still get denied if you don’t meet the lender’s financial criteria.

As a result, these small down payment mortgages are attractive because they make homeownership more accessible. You can save enough for a down payment much sooner than if you had to put the full 20% down, and you can secure a mortgage even if your credit isn’t perfect.

Why a small down payment could end up costing you more

Home loans with a small down payment are often billed as affordable options for homebuyers because of the fact that you don’t have to bring as much money to the table upfront. But the flipside is that you’ll likely spend more money over the life of your loan than if you waited until you had saved enough to make a larger down payment.

For example, let’s say you’re buying a $200,000 home, putting 3% down, and not rolling your closing costs into the loan. On a 30-year mortgage with a 4% interest rate, your monthly payment will consist of the following elements:

  • Principal: The amount of each payment that goes toward reducing your loan balance.
  • Interest: The amount of each payment that goes toward paying the interest on the loan.
  • PMI: Private mortgage insurance paid to a third party to protect the lender in case you default on your loan. For our example, we’ll assume a 0.75% rate.
  • Homeowners insurance: This covers certain damages to your home, the loss of personal belongings and covers your liability in the case that you accidentally injure someone or damage his or her property. Lenders typically require homeowners insurance and collect your payments in an escrow account, making payments to the insurance company for you. We’ll assume a $70 monthly insurance payment for our example.
  • Property tax: Your property tax rate will depend on your state and county. For the sake of simplicity, we’ll use a 1% tax rate for our example.

Using MagnifyMoney’s parent company, LendingTree’s online mortgage calculator, here’s how your monthly payment will break down:

  • Principal and interest: $926.19
  • PMI: $121.25
  • Homeowners insurance: $70
  • Property tax: $166.67

If you total these up, your monthly payment will be $1,284.11.

Now, let’s compare that with your monthly payment if you make a 20% down payment instead.

 

3% Down Payment

20% Down Payment

Principal and interest

$926.19

$763.86

PMI

$121.25

$0

Homeowners insurance

$70

$70

Property tax

$166.67

$166.67

Total Monthly Payment

$1,284.11

$1,000.53

That’s a savings of $283.58 per month, for a total of $102,088.80 over the life of the loan.

What you could do with the money you saved by making a bigger down payment

Even if you don’t plan on staying in the home for the full 30 years, having an extra few hundred dollars per month can make a big difference for your budget. Here are just a few things you can do with that additional cash.

  • Invest: Whether for retirement or some other long-term goal, investing could be one of the best ways to get your money to work for you.
  • Pay down debt: Student loans, credit cards, and other debts are easier to pay off when you have extra room in your budget.
  • Save: Saving ahead for home repairs and routine maintenance, as well as building an emergency fund to handle big, unexpected expenses.
  • Travel: More disposable income makes it easier to travel, whether you want to explore somewhere new or simply visit friends and family.
  • Home improvement: If your new house isn’t your dream home, you can use the monthly savings to work on renovations.

If you do plan on staying in your house for the life of the loan, that extra $102,088.80 can go a long way toward securing every part of your financial future.

How to decide if a low down payment mortgage is for you

While it’s generally better to make a bigger down payment, there are some situations in which a small down payment mortgage may be the better option.

You don’t plan on staying in the home very long

Over a 30-year period, you can save tens of thousands of dollars by opting for a higher down payment. But if you’re only planning on staying in the home for a few years, the savings won’t be nearly as high.

That said, it’s important to also consider the transaction costs.

“The cost of buying and then selling a home runs about 8% to 10% of the purchase price, depending on where you live,” said Casey Fleming, mortgage advisor and author of “The Loan Guide.” “Buying with a low down payment only makes sense if you plan on being in the home long enough to make back at least your acquisition and sale costs.”

You need the liquidity

Even if you have enough money to make a large down payment, you may not want to part with all of it. For example, you might prefer to keep your emergency fund intact rather than deplete it. Or you might want to keep some cash available for repairs. Or you might want to invest some of that money with the hope of getting a better rate of return.

“With a larger down payment, you’re taking money that’s liquid and making it illiquid,” said Dan Green, founder of Growella and the branch manager for Waterstone Mortgage in Pewaukee, Wis. “The only way to get to your money is to refinance, sell your home or take a line of credit. It’s very important that before making a large down payment that you have a sufficient emergency fund, a budget set aside for home repairs.”

Ways to build up to a larger down payment

If you’ve set a goal of making a 10% to 20% down payment on your next home purchase, now is the time to start getting your strategy in place. While it can sometimes take years to save that kind of money, there are a few things you can do to speed up the process.

Find extra cash to save

Sometimes one of the best ways to reach a financial goal is a good mix of offense and defense.

On offense, consider finding ways to earn more money either by negotiating a raise, starting a side hustle, getting a second job or booking the occasional side gig.

On defense, create and maintain a budget to find areas where you can cut back. Set a monthly goal for how much you want to save, automate that savings and funnel any extra cash toward your down payment fund. Tools like You Need a Budget and Mint.com can help you create and execute this plan.

Pros

  • The opportunities to earn extra money are virtually endless.
  • You have control over how and where you spend your money.
  • Negotiating a raise at your current job can provide extra money without requiring extra work.
  • Starting a side hustle could bring in extra income long after you’ve reached your down payment goal.

Cons

  • These strategies can require more time than other options.
  • If you have a lot of debt and other essential expenses, cutting back can be hard.
  • Creating new habits and sticking to them can be difficult. You have to be committed for the long run.

Borrowing from family or friends

If a friend or family member is willing to loan you money, you might not have to spend time finding extra cash. You may even be lucky enough to receive the money as a gift — subject to federal gift tax rules — which would provide the money at essentially no cost to you.

However, if you are structuring it as a loan, Neal Frankle, a certified financial planner and the founder of Credit Pilgrim, recommends adhering to the current guidelines for Applicable Federal Rate (AFR), which specify minimum interest rates for various types of loans.

Pros

  • You’ll get into your new house sooner.
  • You can often get a lower interest rate from family or friends than you’d get from a lender.
  • You may have more flexibility with the repayment terms.

Cons

  • It can damage your relationship if something goes wrong.
  • Your family members or friends may not consider you trustworthy enough to loan money.
  • Not all mortgage lenders allow you to borrow your down payment.

Borrow from your 401(k)

Qualified retirement accounts like a 401(k) typically penalize you for taking withdrawals before you’ve reached retirement age.

But many 401(k) plans offer loan programs that allow you to borrow from your account balance, often with relatively low-interest rates even if you have poor credit. And if you are using the money in order to purchase a primary residence, you may be able to pay the loan back over a period of 25 years, as opposed to the standard 5-year term for most 401(k) loans.

Pros

  • You can get into your new house sooner.
  • 401(k) loans often have lower interest rates than a personal loan.
  • The interest you pay goes back into your 401(k) account rather than to a lender.

Cons

  • You’re forfeiting potential investment gains on the borrowed money.
  • If you leave your employer for any reason, your loan may be due within 90 days, putting you in a difficult financial position.
  • Not all 401(k) plans offer loan programs.

The bottom line

There are certain situations where a small down payment mortgage might be a good idea. It can get you into a home sooner, and many federally-insured mortgage programs can minimize the costs and allow you to buy a home with less-than-perfect credit.

But in many cases, it’s better to go above and beyond the minimum down payment required. A larger down payment can save you money both in the short term and the long term, helping you invest more in your future financial security.

Making the right choice for your personal situation involves both running the numbers and taking your personal goals into account. If you do your due diligence, you’ll be in a better position to make a good decision.

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