If you’re thinking about buying a house one day, then you may have heard that coming up with a mortgage down payment is a big obstacle, possibly even the biggest. But unless you’ve bought a car or made another big purchase, the words “down payment” might not mean anything to you at all … except perhaps representing one more thing you don’t know about buying a house.
Most home purchases are made with the help of a mortgage loan, The National Association of Realtors® (NAR) said in 2020 that 87% of home purchases were financed.
Most of those loans require some kind of down payment. That money is the main thing standing between many would-be homeowners and their dream house because a down payment on a house is a large sum. This is partly thanks to home prices, which have been climbing steadily (with few areas of exception) since the Great Recession.
The median existing single-family home sold for $313,000 in October 2020, as measured by NAR. And in 2020, the overall median down payment was 12%, equal to $37,560 on the median-priced house. Average down payment amounts ranged from 7% for first-time buyers to 16% for repeat buyers.
A 7% down payment might sound small; for a house that costs $313,000, however, 7% is $21,910, not to mention the closing costs you’ll need to pay, which can tack on up to 2% to 5% of the loan amount. Coming up with that much money is a challenge for many home shoppers. Not a few turn to family members for help. Many delay their home purchase for months or years while they build up a down payment savings account.
Before embarking on a project that long and challenging, it’s a good idea to understand what down payments do, how they affect your mortgage, and how big your down payment should be. You can use a down payment calculator to help with this decision. Meanwhile, here’s what else you need to know.
How the down payment affects your mortgage
The down payment affects, first of all, the type of loan you can get. Most lenders require you to put something down. But there are some exceptions.
For example, if you are a service veteran, you may be eligible for a zero-down loan backed by the Department of Veterans Affairs (a VA loan). Otherwise, barring a specialized loan or down payment assistance program, you’re generally looking at making some sort of down payment.
Different types of loans call for different down payments. Here’s why: The down payment impacts an important factor called the loan to value (LTV) ratio, or how much you’re borrowing compared to how much the home is worth.
To figure out the LTV ratio, first find the loan amount by subtracting the down payment amount from the purchase price, then divide the loan amount by the purchase price of the house. (Exception: If the purchase price is more than the appraised value, divide the loan amount by the appraised value.)
(Purchase price of home – Down payment) / Purchase price of home = LTV ratio
(Purchase price of home – Down payment) / Appraised value of home = LTV ratio
Here’s an example:
The buyer of a $300,000 home puts down 12%, or $36,000, to buy the house. That means the loan amount will be $300,000 minus $36,000 or $264,000:
$300,000 – $36,000 = $264,000
To calculate the LTV ratio, divide $264,000 by $300,000 to get 88. Expressed as a percentage, this is 88 percent. The LTV ratio is 88%.
$264,000 / $300,000 = 88%
The LTV is important because it affects the lender’s perception of risk. A higher LTV, when all other factors are equal, is a riskier loan from the perspective of the lender. The lender’s view of exactly how risky your loan is will affect the terms and cost of the loan you are offered.
For example, a higher LTV ratio usually means a higher mortgage interest rate. And just fractions of percentage points in the interest rate can have a big effect on the total amount of interest you’ll pay over the life of the loan. The interest rate also affects the size of your monthly payment.
Even more importantly, the LTV impacts how much you can qualify to borrow. Because the size of the loan you can get affects the price of the house you can buy, this makes the size of the down payment a big factor in affordability.
Down payments and debt-to-income ratio
A down payment can also reduce your debt-to-income (DTI) ratio, which looks how much you pay in debts each month compared to how much income you bring in. This is another key figure lenders look at when evaluating a loan request.
To figure your DTI ratio, total all your monthly debt payments, including auto and student loans, credit card minimum payments, and the payment for your proposed mortgage. Then divide this number by your gross monthly income and express the result as a percentage.
(Total monthly debt payments + Proposed mortgage payment) / Gross monthly income = DTI ratio
That’s your DTI ratio. If it is more than about 45%, depending on the lender, you may not qualify to borrow that much. Typically, lenders like to see a DTI of 43% or lower.
To change your DTI ratio, you have a few options. You can increase your income, which may not be easy. You can also decrease your other debt payments. Or you can decrease your proposed mortgage payment by asking to borrow a smaller amount.
One way to borrow less is to buy a less expensive house. A bigger down payment is another option because it means you’re borrowing less money, so both your monthly mortgage payment and DTI ratio will decrease.
This may be your best or only way to buy the house you want.
“There are guidelines in place that a lender will only lend for certain DTIs,” says Jeremy Larkin, who works with 73% more single-family homes than the average agent in Houston, Texas. “You may have to infuse more cash so you can lower your debt ratio.”
Sellers and down payments
Sellers also like to see a larger down payment. That’s important in a hot housing market, when homes may have several bidders competing for the deal.
“In a competitive offer situation, either cash or having a higher down payment is going to win the deal,” Larkin says. Sellers want a buyer whose financing won’t fall through at the last minute, potentially leaving them in the lurch, he explains.
When a borrower puts more money down, there is perception that there is lower risk that the loan could potentially get turned down right before closing. Sellers assume that a higher down payment will indicate the buyer has sufficient cash to cover any last minute shortfalls in financing.
This same rationale can apply with appraisals. An appraisal coming in low can be another barrier to closing that a larger down payment might help you navigate. If you are offering more than the home’s asking price, or were involved in a bidding war, then it’s possible the appraisal will be lower than the purchase price of the home, which can put the loan in jeopardy. Being able to cover the difference in value in cash is how you ensure that your lender will still make the loan, even if it appraises lower than everyone had hoped.
20% down – nice or necessary?
If you ask a typical person what the down payment on a house is, the figure you’ll hear most often is “20%.” As the statistics on homebuyers show, of course, the median figure is considerably less.
Still, if you can, there are reasons for putting down 20% on a house, even beyond getting a better loan and getting your purchase offer accepted. One is that putting 20% down means you won’t have to pay for mortgage insurance (MI).
Mortgage insurance protects lenders in case a borrower doesn’t pay back the loan. Although it’s meant to cover lenders, borrowers pay for it. Mortgage insurance premiums can add hundreds of dollars to your monthly mortgage payment.
A bigger monthly mortgage payment means a higher DTI ratio, which can make it harder to borrow enough money to do the deal if you’re already hovering around that 43% benchmark. Putting down 20% and avoiding MI can keep you at a healthier DTI.
Still, putting down 20% isn’t always the best move. When interest rates are low, making a larger down payment doesn’t change the interest portion of your payment much, Larkin notes. There may be smarter moves to make with your hard-saved cash.
As of the end of 2020, “money is cheap to get,” Larkin observes. If you can get approved with less money down and are confident your offer won’t be rejected because of shaky financing, he sees no reason to put down more unless you are making a 20% down payment to avoid MI.
“You could take that extra money and put it in the stock market and in hopes of growing long-term wealth,” Larkin says.
“Why put money in a house that appreciates at 2% to 3% a year — maybe — when you can put it in the market and potentially get 8 to 10% returns?”
There are always other investments that can be made with cash in hand, so it may make sense to put less down and diversify your investments. Or keep the extra cash in savings for improvements or emergencies.
Low down payment options
The type and source of your loan influences how much you’ll need to put down. Different loans and lenders call for different down payments.
Here are the main sources and minimum down payment requirements.
- VA loans: Eligible veterans can qualify for loans with no money down through the VA’s loan program.
- FHA loans: Federal Housing Administration accepts loans with as little as 3.5% down.
- USDA loans: The US Department of Agriculture has a zero-down loan program primarily available in rural areas.
- Conventional loans: Conventional loans such Fannie Mae’s HomeReady program can be approved with as little as 3% down for certain qualified buyers.
Assembling your down payment
It’s not unusual for first-time buyers to turn to other family members for help buying a home. The NAR survey found 26% of buyers — more than 1 in 4 — had family help with the down payment.
Another potential source is a down payment assistance program. There are literally thousands of these, including many run at the local and state level, available in nearly every market in the country. Some require funds to be paid back like a second mortgage. Others are forgivable loans, and still others make outright grants.
Each down payment assistance program has different qualifying standards and application processes. But for eligible buyers, these can help a lot with a down payment.
Calculating your ideal down payment
To decide how much to put down, start by deciding what’s most important. Is it the rate? The monthly payment? The larger amount of equity you’ll have from the start with a bigger down payment?
Use an online down payment calculator to see the effect of differently sized down payments on interest, payment, MI and other factors.
Next, calculate how much money you actually have available to you. Include possible gifts from family members if that’s appropriate.
Don’t plan to put every last penny you have into the down payment. You’ll need cash for moving expenses, closing costs, possible repairs, and other financial goals — such as vacations and buying a new car.
It can take some time to save up for a down payment. The larger the down payment, the longer it’s likely to take. Putting some effort into thinking about how a down payment affects your loan amount and how much you will want to put down can have a major impact on how much you need to save … and how long you’ll have to wait before buying a home.
Header Image Source: (Karolina Grabowska / Pexels)