Understanding Mortgage Down Payments: How Much Should You Pay?
Becoming a homeowner is as exciting a time as any, but it is also a move that requires a serious financial commitment. And unless you were able to purchase 100% of your home with cash savings, you are committing yourself to a mortgage that will command monthly payments for up to thirty years.
As a homebuyer, paying off your mortgage will be a financial priority for quite a long period of time. But, there is another financial aspect of the home-buying process that only needs to be dealt with when you close on your home: the down payment.
The down payment you make on your house is a crucial step in becoming a homeowner, and can greatly impact the terms you receive for your mortgage loan. It is also something that requires a good deal of financial preparation, specifically saving up enough cash over an extended period of time so that you can make a considerable down payment that will likely improve your mortgage terms.
So, let’s understand more about down payments and the impact that this component of the home-buying process can have when closing on your house.
What is a Down Payment on a House?
A down payment is the cash that you pay upfront to purchase a home. The amount of your down payment is reduced from the total sales price of your new home, and the remaining balance is your mortgage.
The down payment is given to the seller of the home, while the remaining payments left to be made on the house are directed to your mortgage lender. So, the seller of the home receives full payment for the house, other than your down payment, from the mortgage lender, who recoups their debt via mortgage payments that you make plus interest.
Whatever the size of your down payment winds up being, that is your beginning equity, or ownership stake, in the house. A down payment is expressed as a percentage of the total home purchase price, and it is generally recommended that you make a 20% down payment.
For example, let’s say you are getting close to closing on a home with a price tag of $1,000,000.
In example one, you make a down payment of 10%, or $100,000. You pay the home seller $100,000 and the size of your mortgage loan is $900,000. Your beginning ownership stake in the home is 10%.
In example two, you make a down payment of 20%, or $200,000. You pay the home seller $200,000 and the size of your mortgage loan is $800,000. Your beginning ownership stake in the home is 20%.
Why is a Down Payment Required by Mortgage Lenders?
For a mortgage lender, whether it is a traditional bank or non-traditional lender like Quicken Loans, the down payment on a house simply mitigates their risk.
Every extra percentage of equity that you take on because of your down payment is one less percent of the home’s total purchase price that the mortgage lender is on the hook for.
For example, if you make a 20% down payment on a $1,000,000 home, then the mortgage lender is only covering $800,000. By comparison, if you make a 10% down payment on that same home, the mortgage lender is now covering $900,000. If you no longer can make down payments on this home and default on the mortgage loan, the mortgage lender would rather be susceptible to losses of $800,000, not $900,000.
Because of the added financial vulnerability that a lender takes on when you make a smaller down payment, private mortgage insurance (PMI) is often required for down payments less than 20%. PMI increases your monthly home loan payments, but protects the home loan lender by repaying them the portion of the mortgage that you default on.
Benefits of a 20% Down Payment
Ideally, you are able to make a 20% down payment on your home. Remember, a lender wants to see you make a larger down payment, and there are benefits that come with a 20% down payment, including:
Lower mortgage interest rate as a lender is more inclined to give favorable mortgage terms if there is less risk for them.
More equity in your home from the beginning.
Offset negative equity risks in case your home loses value from market fluctuations.
Avoid PMI and other ongoing fees that would otherwise increase your monthly mortgage payments.
Low Down Payment Mortgage Alternatives
If you are unable to put forward the cash for a large down payment, or are simply interested in other options, there are a couple of low down payment mortgage alternatives that come to mind.
First, FHA loans are a type of mortgage that can be had with a down payment as low as 3.5%. This is a home loan guaranteed by the federal government, meaning the Federal Housing Administration (FHA) will insure a portion of the home loan for the mortgage lender.
Because the mortgage lender is guaranteed a portion of the mortgage loan no matter what happens, they are more willing to provide home loans with minimal down payments.
Second, are two other types of government-backed loans: VA loans and USDA loans. Similar to FHA loans, VA and USDA loans are both backed by the federal government. The latter is insured by the Department of Agriculture, while the Department of Veterans Affairs insures the former.
With these two type home loans, it is possible to qualify for a zero down payment mortgage. In other words, you will not have to put any money down upon closing on your home. And, even if you can’t get a zero down payment mortgage from these two sources, the down payment will still be quite low since the mortgage lenders are insured.
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