Down Payment on a House: What is it and how to determine what amount down works for you?

Down Payments: Everything you need to know as a first-time homebuyer

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Buying a home is one of the largest financial decisions most people will ever make. It is also a process that requires a significant amount of preparation, from saving for your down payment to understanding purchase agreements, we are here to help you understand the fundamentals so that you are fully prepared for your transaction.

Arguably one of the most, if not the most important thing to think about when entering the housing market is the down payment amount you will pay, especially as a first-time homebuyer. The down payment amount you select impacts other financial aspects of the deal - mainly the interest rate of your mortgage loan.

One of the biggest misconceptions in real estate is that first-time homebuyers and even repeat buyers are required to put down 20% of the home value as their down payment. In reality, this actually isn’t the only option and there are a number of alternatives available that will make homeownership more accessible for buyers.

What is a down payment? 

A down payment is the percentage of a home's listing price that the buyer pays upfront to the seller when they purchase the home. This money is put towards the total purchase price or cost of your new home, and the remainder is usually paid via conventional loan or mortgage loan.

What down payment amount do you actually need to pay?

The amount required for a down payment varies based on a number of factors, but buyers normally can expect to pay anywhere from 3% to 20% of the home’s purchase price.

For example, if a home costs $1,000,000, the down payment amount could range from $30k with 3% down to $200k with 20% down.

This range in percent down depends on factors like the type of mortgage or loan program you’re using and whether it’s a conventional mortgage, VA loan or USDA loan. Your financial health also is a critical factor in this, with lenders looking at things like your debt-to-income ratio, types of loans you qualify for, and even the home value or anticipated sale price.

It’s worth noting that if borrowers opt for a lower down payment amount to purchase their new home, like a 3% or 5% down, then their mortgage rate will be higher than they would be with a large down payment, like a 20% down option. There are also much stricter requirements for a lower down payments than there are with the larger down payment amounts.

Requirements for Down Payments Under 20%

One of the requirements for down payment amounts that are under 20% is that you will have to pay (PMI) Private Mortgage Insurance. PMI safeguards the mortgage lender in the event that the borrower defaults on their loan. It's a legal requirement for most lenders used to protect their investment in case you can no longer pay for the loan. 

The cost of PMI is a percentage of the buyer’s mortgage loan amount and will be added to their monthly mortgage payment.

Paying private mortgage insurance is typically required until the borrower reaches a certain level of equity in their new home. 20% of the home’s value is usually the amount of equity needed to stop paying PMI. Once you reach this 20% equity threshold, borrowers can normally end the PMI payments, but always make sure to check with your mortgage lender to confirm. 

How do down payments work?

Down payments work by decreasing the amount of the mortgage that the lender provides to the borrower. This means that the lender is taking on less risk in lending this buyer money and the buyer is taking on more by not having as much home equity.

Put simply, the main purpose of a down payment is to reduce the amount of loan money that the homebuyer needs to borrow from a mortgage lender, which in turn makes the loan payments more affordable for the borrower.

The loan-to-value (LTV) ratio is another term that buyers might hear when they start exploring their down payment options. The loan-to-value ratio looks at two factors - the home loan amount and the appraised value of the home being purchased. These numbers are then used to calculate the LTV by dividing the mortgage loan amount by the appraised value of the home.

LTV = mortgage loan amount / appraised value of home

The down payment is key in determining the LTV ratio, so be sure to know what down payment amount would be reasonable for you prior to meeting with a mortgage lender.

A good rule of thumb to remember for down payments is that the higher the down payment amount, the lower the LTV ratio will be, which is better for lenders because it means they are taking on less risk.

The down payment is also typically paid at closing, when the mortgage loan is fully funded and the title to the home is transferred to the new owner. The down payment funds can come from a variety of sources, including savings, an emergency fund, a monetary gift from family members, or the money from selling another home or property.

The larger your down payment amount, the lower the monthly mortgage payments will be. A larger down payment reduces the amount that the lender must shell out, which in turn reduces the interest rate paid over the life of the loan.

Common homebuyer misconceptions about down payments:

1. 20% down is required to buy a home: While it is true that 20% down can help borrowers avoid private mortgage insurance (PMI), it's actually not a requirement for buying a home. There are a range of options for down payments including low percentage (3-5%) or 0% down options available. There are also special programs like FHA loans and VA loans (offered through the Department of Veterans Affairs) that have different down payment requirements, so be sure to research what will work best for your situation. 
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2. Buyers cannot use gift money for down payments: Homebuyers are in fact allowed to use gift money for their down payment, but there are a few caveats. If the home will be the buyer’s primary residence, then they are permitted to use gift money for all or some of their down payment. If the buyer is looking to purchase a second home or investment property, then there might be restrictions on using gift money for the down payment, but be sure to check with your lender.
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3. A high credit score is required to get a low down payment loan: Having a strong credit score does help in securing a better interest rate for your mortgage, but again there are also low down payment options available for those who have lower credit scores. So, a high credit score is not technically required in order to get a lower mortgage rate, as there are options to choose from in these scenarios.

What are the typical options for down payments?

1. Save for a 20% down payment: This is usually the most expensive route and typically requires the most effort, but it's the most straightforward. Buyers will need to save 20% of the home’s purchase price and put it towards their down payment amount when they identify a home to buy.
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2. Secure a 3-5% or 0% down payment loan option: There are many types of down payment assistance programs available, including FHA loans and VA loans, that allow buyers to purchase a home with as little as 0-3% down. These loans often have higher interest rates and stricter requirements, though, so be sure to speak with a lender about the financial implications for your situation.
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3. Use a down payment assistance program: There are a number of programs available that can help buyers come up with down payments. Buyers will need to research the options available in their location to see if there is a viable assistance program option that will work for their situation.

Who regulates mortgage lenders and down payment requirements?

The main regulatory bodies associated with mortgages are: the NMLS, Fannie Mae, and Freddie Mac. Each of these institutions plays a different, yet critical role in the residential mortgage market.

The Nationwide Multi-state Licensing System (NMLS) is an online service that provides centralized regulation of the mortgage industry and helps state regulators share information efficiently with one other. The NMLS requires mortgage loan originators or lenders to be licensed and to follow the state and federal laws around lending. These include laws related to mortgage lending practices, such as the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA).

These laws and regulations can affect down payment amounts, as well as other aspects of the home mortgage process, such as the financial disclosures required to be provided to borrowers and the fees charged by the mortgage lenders.

Fannie Mae and Freddie Mac are government entities that play an important role in the mortgage market. They were established to provide liquidity, stability, and affordability practices to ensure that homeownership remains accessible for all variations of buyers. Freddie Mac and Fannie Mae have established rules for the types of mortgages they will purchase. The rules usually require a minimum down payment amount.

For example, for a traditional or conventional mortgage, Freddie Mac and Fannie Mae require a minimum down payment of 5%, while some other lenders may require amounts closer to 10-20%.

Be sure to research all of your options for down payment amounts

As a homebuyer, there are a plethora of topics that you need to think about, and it can feel very overwhelming, especially for first-time homebuyers.

The first thing we recommend thinking about and planning for is the down payment amount you’d be comfortable paying. Remember that the amount you need to put down for a down payment varies, but you can estimate that it will be between 3% to 20% of the home purchase price.

There are many misconceptions about down payments, but with the right information and access to options, you can find the best fit for your unique situation.

Whether you choose to save up for a traditional or more conventional down payment of 20%, use a low or 0% down payment loan, or utilize a down payment assistance program, it's of the upmost importance to do your research and make an informed decision, so you don’t regret your purchase later!

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