Understanding Down Payments

In this topic, you'll learn:

  • Common down payment options.
  • Why a 20% down payment can save you money.

A piggy bank on the welcome mat of a home.

When it comes to putting away money for a house, here's some indisputable advice: start early, save often.

Building a sizeable nest egg makes the entire process - including securing a mortgage with good terms - much easier to navigate. Unfortunately, statistics show that many of us just aren't that successful when it comes to saving for such a long-term goal. Having a clearly defined goal and a strong incentive certainly helps, however, and a new home qualifies on both counts. With that in mind, let's talk about the basics of saving for a down payment.

Down Payment Myths

While a 20% down payment is ideal, many people mistakenly believe that a 20% down payment is required. A down payment of 20% or higher is great since you'll generally be able to avoid the expense of private mortgage insurance (PMI), but most home buyers don't make a 20% down payment - the vast majority make down payments of 10% or less.

Lenders realize that not everyone is capable of saving a substantial down payment and often accept down payments as low as 5% or less. There are even government programs that, if you qualify, can reduce your down payment to a few percentage points or even zero in some cases. Examples of government home lending programs include Federal Housing Administration (FHA) loans for first-time buyers and Veteran's Administration (VA) loans for military veterans. There's even a US Department of Agriculture (USDA) loan program for those in certain rural areas.

Even though the 20% down payment requirement is a myth, there are benefits to putting down as much as you can comfortably afford. Larger down payments may make it possible to finance your home for a shorter term - saving on interest charges. Larger down payments mean you'll have more equity in your home right away - making it easier to qualify for low-interest home equity loans. And if you can make a down payment of 20% or more, you'll be able to avoid PMI expenses of hundreds of dollars per year (or more).

How to Save

As with any savings goal, it's smart to begin saving as soon as possible. In addition to the benefits of a larger down payment, the ability to consistently save for such a long-term goal is a great sign that you're ready for responsibilities of home ownership.

There are many strategies for saving money, like setting up an automatic checking to savings transfer. But unless you're saving for more than four or five years away, most experts suggest putting your money into a savings account or Certificate of Deposit (CD) - not stocks and other high-risk investments. While the long-term appreciation of stocks is higher than savings accounts, stocks can quickly go up and down in value. Saving in a risk-free account ensures that the money is available when you need it, so you'll be in a strong financial position when it's time to finally buy.

In addition to growing your savings, an important part of your strategy should be to reduce high-interest debt - especially credit card debt. Even the best mutual fund or stock can't reliably earn more than the cost of maintaining a credit card balance. So if you do have significant credit card debt, it's a good idea to pay it off or minimize it as much as possible. Reducing debt also improves your debt-to-income ratio, which is a key criterion lenders consider when making mortgage loans.

Especially when preparing for the purchase of a home, the lower your debt, the better.

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