June 09, 2016
My absolute best advice is to strive to make a 20% down payment when you buy a home. I know that can be a lot of money. But hear me out. What you need to understand is that a small down payment can end up costing you big time.
FHA-InsuredOne of the more popular low-down payment options is an FHA-insured mortgage that requires a down payment of just 3.5%. Sounds great? Slow down. There are two layers of extra fees charged for an FHA-insured loan. First, there’s a one-time up front fee equal to 1.75% of the loan amount. On a $200,000 loan that is an additional $3,500. Yes, that sum can be rolled into your mortgage-that’s how the lender makes it palatable-but that just means you will be paying interest on that fee for the life of the loan.
The second fee on an FHA-insured loan is called the annual mortgage insurance premium (MIP). For a loan with a down payment of 3.5% the MIP is typically 0.85% a year. (It rises to 1.05% for FHA-insured loans in high cost regions.) Even once you’ve paid down the principal to the point where you have at least 80% equity (or your home’s value has appreciated) you are still stuck with this payment. The only way you can get rid of MIP is to refinance. That may indeed be an option, but what if when you are ready to refinance interest rates are a lot higher?
The Conventional Route
Lenders also offer so-called “conventional” mortgages with low down payments. A conventional mortgage with a down payment below 20% requires that you purchase private mortgage insurance. (PMI). If you have a high credit score, PMI for a conventional mortgage will typically cost you less than the costs of an FHA-insured mortgage. But again, I want to stress that there is no free lunch. In mid 2016 someone with a fantastic FICO credit score (760+) would have a PMI charge equal to 0.55% of the mortgage amount. With a FICO score between 700 and 759 the PMI charge ranges between 0.75% and 1.15%. It’s still costing you plenty! That said, another advantage over an FHA-insured loan is that once your equity rises to 20% with a conventional mortgage the lender must cancel the PMI.
The 20% solution
Okay, so now you know an important reason why I like a 20% down payment. That’s the threshold where all special insurance/funding fees disappear.
I realize that can be a lot of money. But 20% becomes more doable if you lower your housing budget. The lower the purchase price, the easier it is to get to 20%. Or push yourself to get as close to 20% as possible and take out a conventional mortgage assuming you have a high credit score. That reduces the time it will take to get to the 20% equity level that will allow you to get rid of the PMI.
Down Payment Don'ts
I don’t want you to ever touch your retirement savings for your down payment. Spend that money now, and what will you have in retirement? Nor are you to spend down your emergency savings. That’s not smart financial planning, and besides, it will likely backfire on you as lenders are going to scour your cash flow. They typically want to see you have ready cash that can cover three to six months of mortgage payments. If using your savings for a down payment reduces your emergency fund to the danger zone, you might not get approved for the loan in the first place.