Should You Borrow Money for a Down Payment on a Home?

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Homeownership is an exciting prospect, but even if you can afford the monthly mortgage payments, coming up with a down payment can be a big obstacle. That’s especially true if you want to put down 20% to avoid paying extra for private mortgage insurance (PMI), which many lenders require as protection against default.A down payment, though, certainly isn’t cheap. A 20% down payment on a $300,000 home would mean you’d need $60,000 in cash. Even a modest 5% down payment still means coming up with $15,000 in upfront cash. Plus, that doesn’t include the other costs associated with buying a home like closing costs, attorney fees, escrow and more. It may make sense to borrow money for a down payment because it can up your chances at getting a mortgage, lower your monthly mortgage payments and cost you less in interest over time.

And if you can get to 20% and avoid having to pay for PMI, even better. PMI payments can equal 0.5% to 1% of the entire loan amount, and you have to pay PMI until you reach at least 20% equity in your home, which could take years. Let’s say you have a $250,000 mortgage and have to pay PMI because your down payment was 10%. At the high end of PMI costs (1%), you would pay $2,500 a year, or roughly $208 a month, for PMI.

So should you borrow money from sources like a bank, family member or your 401(k) for a down payment? The will depend on how much interest you’ll be charged, whether borrowing would allow you to avoid paying PMI and how it helps or hurts your chances at being approved for a mortgage.

Here is a look at several options, and their pros and cons, for borrowing money for a down payment.

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How to borrow money for a down payment

Borrowing against equity you have in an existing property

If you already own a home, you may be able to borrow against the equity in your current home to buy a new one with a home equity loan or home equity line of credit (HELOC). A home equity loan gives the borrower a lump-sum amount of money upfront, usually with a fixed interest rate. A home equity line of credit (HELOC), meanwhile, gives you access to funds you can draw on as needed. With a HELOC, you only pay interest on what you borrow; most come with variable interest rates.

Pros:

  • Because these loans are secured, with your home as collateral, they usually have lower interest rates.
  • If you borrow enough to reach a 20% down payment, you can avoid PMI.

Cons:

  • Your house is the collateral for the loan, so if you can’t make your payments, you risk losing your home to foreclosure.
  • If it takes longer than expected to sell your home, you may be making two monthly loan payments for a while.
  • Some home equity loans or HELOCs charge prepayment fees if you pay off the loan early.

Borrowing from friends/family

The major benefit of borrowing money from a friend or relative is potentially paying lower interest, having more flexibility in repayment and not having to meet the loan requirements of a traditional lender. If the down payment is a gift, not a loan, most lenders require that it come from a family member and that they provide a letter designating the money as a gift. The IRS allows each person to gift, tax-free, $15,000 a year to one person. A married couple, though, could each give $15,000 to a child every year. If the money is borrowed, it will count as a debt.

Pros:

  • You might be able to get more favorable borrowing terms like lower interest rates.
  • The process should be quicker and easier than most other loan options.

Cons:

  • You risk harming your relationship if you don’t repay the loan or meet the agreement, or if expectations change on either side.

Taking out a 401(k) loan

You may be able to take a loan from your 401(k) for a down payment. Because this is a loan and not a withdrawal, you won’t be hit with the 10% early withdrawal penalty if you’re younger than age 59 ½. However, that penalty kicks in if you default on the loan. The IRS allows you to borrow up to 50% of your vested account balance, or $50,000, whichever is less. For first-time homebuyers, there is also the possibility of withdrawing up to $10,000 for certain approved “hardship” expenses (including buying a home) from some 401(k)s and traditional individual retirement accounts (IRAs) without penalty. If you’re not a first-time homebuyer, then the 10% penalty would apply.

Pros:

  • With a 401(k) loan, you’re using your own money for the down payment, so you’re really just paying back yourself, with interest.
  • If you’re an eligible first-time homebuyer, you can withdraw up to $10,000 from some 401(k) or traditional IRA plans without penalty.

Cons:

  • If you lose your job before you pay off the loan, you’ll have to repay the whole amount by the next tax-filing deadline.
  • If you default on the loan, you’ll be charged a 10% penalty by the IRS, and you’ll be taxed on the remaining balance.

Taking out a personal loan

Personal loans can be used for almost any purpose, are repaid with principal and interest, and usually don’t require collateral. However, they’re not commonly used for down payments because having another loan won’t be appealing to a lender when you apply for a mortgage.

Pros:

  • They often have a faster approval time than other conventional loans.
  • They usually have fixed interest rates, long terms and lower interest rates than credit cards.
  • They can be used to consolidate higher-interest debt, which could improve your finances before you apply for a mortgage.

Cons:

  • A personal loan affects your debt-to-income (DTI) ratio, which could hurt your chances of getting a mortgage.
  • You’ll need to make monthly repayments in addition to future mortgage payments.
  • A lender could react negatively if you plan to use a personal loan for most or all of your down payment because they like you to have skin (i.e., your own money) in the game.

Getting a loan from a community bank or credit union

Community banks and credit unions have similar loan products to big banks, but they often have better interest rates. Credit unions are nonprofit, so they can afford to have lower fees and interest rates. And both credit unions and community banks may be able to offer more flexibility around approval requirements like credit scores and income levels.

Pros:

  • You may be able to get fast financing at a good interest rate that allows you to make a down payment.

Cons:

  • You’ll be paying interest and principal on a loan as well as any relevant fees.
  • Having more debt could hurt your chances of getting a mortgage.

Grants/assistance programs

There are several federal, state and local grant or assistance programs to help people buy homes. Some programs are specifically targeted at helping with down payments and/or closing costs. You can search for programs by state on the U.S. Department of Housing and Urban Development’s (HUD) website.

The National Homebuyers Fund is one organization that offers down payment or closing cost funds of up to 5% of the amount of the loan. The funds come in the form of a zero-interest gift or a second mortgage that is forgiven after three years.

Then there are federal government-backed programs that allow eligible buyers to put down lower down payments, such as the Federal Housing Authority (FHA), the U.S. Department of Veterans Affairs (VA) or the U.S. Department of Agriculture (USDA).

The FHA’s loans allow buyers to provide down payments as low as 3.5%. With VA loans, eligible buyers may be able to get a loan without needing a down payment at all, depending on how much they want to borrow. The USDA, likewise, offers various lending programs that help reduce the costs of buying a home, including the Section 502 Direct Loan Program for low- and very low-income applicants in rural areas, which doesn’t require a down payment.

Pros:

  • Assistance programs can lower, or even eliminate, the need for a down payment.
  • Although credit history and other factors still matter, borrowers may be more likely to get a loan that is backed by the government because that factor takes away some of the risk for the lender.

Cons:

  • If someone uses a loan from the FHA to make a smaller down payment, he or she may need to take out PMI until they reach 20% equity.
  • Putting down a smaller down payment also demands taking out a larger mortgage to buy the home.

Conclusion

Homeownership is a big step, and there are plenty of options to help you come up with the money for a down payment. Even if you have enough cash to put down 20%, you might not want to do so if that means cleaning out your savings.

Avoiding paying PMI, though, can save you thousands of dollars, so it can make financial sense to borrow enough for a 20% down payment if you’re close. Having a larger down payment can also help you get a mortgage and will mean smaller monthly payments. So weigh your options, such as borrowing from friends or family, taking out a loan from a bank or credit union, taking a loan from your 401(k) or borrowing against equity in your current home.

If you don’t have much cash for a down payment, it’s also worth looking into grants and down payment assistance programs that can reduce the amount you need for a down payment or even eliminate the requirement for one altogether.

The important thing is that you can afford whatever borrowing option you choose. Make sure you can financially handle paying off both a down payment loan and a future mortgage. Also, be sure that the option you choose will help you get into a home more quickly and easily, instead of counting against you.

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Jennifer Thomas
Jennifer Thomas |

Jennifer Thomas is a writer at MagnifyMoney. You can email Jennifer here

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