Pros and Cons of a Low Down Payment
Conventional loans typically require the homebuyer to pay a 20% down payment. For a $250,000 home, this means coming up with $50,000 plus the closing costs. For many first time homebuyers, coming up with such a large down payment seems daunting, so they turn to low down payment programs such as FHA (3.5% down), USDA (0% down), and VA (0% down). This seems like a perfect idea. However, there may be some drawbacks to using a government insured program.
Let’s look at the pros and cons of putting down less than 20%.
Pro: Gives You More Money for Closing Costs
Closing costs and money needed in your savings account for reserves can often be over 10% of the purchase price of your home. If you don’t have to put 20% down on your home, you can use the money saved from having a low down payment to help with the closing costs.
Pro: Gives You Money To Do Other Things
Whenever you spend money in one place, it keeps you from spending it somewhere else. This is known as the opportunity cost. If you don’t have to put 20% into your home, you can use that money for other things such as investing, other large purchases such as cars or college tuition, enjoyment such as vacations, or simply keeping the money for a rainy day fund. Many people like having these options available to them by using a low money down program rather than sinking all their money into their home.
Con: May Include Higher Interest Rates
Since mortgage lenders factor in things such as the loan size, your credit history, and your down payment to determine your interest rate, some loans with a low down payment have higher interest rates. In general, the more you make in a down payment, the lower your interest rate will be. This is because the loan is less risky for the bank.
Con: Have to Pay Private Mortgage Insurance (PMI)
In addition to paying your mortgage, many loans with a low down payment will require you to carry private mortgage insurance (PMI). Private mortgage insurance typically costs between 0.5% and 1% of the loan amount annually. NOTE: The VA loan does not require PMI.
Con: Higher Closing Costs
Some of the closing costs are based on the size of the mortgage. If you pay less in down payment, then the mortgage you take out will be larger. This means that the closing costs will be higher as well. For instance, origination fees are based on loan amount. So, if you buy a $250,000 house with 20% down and have a 1% loan origination fee, you will pay $2,000. On the other hand, if you only put 5% down, then your loan is $237,500, and the fee will be $2,375.
Con: Lower Equity
Having low equity in a home can be risky. For instance, if homes devalue, you can easily find yourself in an upside down loan. Since it will take you years to begin gaining any equity, you will also be limited in your refinancing options.
Of course, some of these cons associated with a low down payment are mitigated through different government insured programs. Be sure to look at all the different programs to determine what works best for you and your unique situation. Please give us a call to get a list of preferred lenders who can help you find the right mortgage product as you begin your home search.