How Much is Really Enough for a Down Payment?
So you’re tired of weird Craigslist roommates, stark white walls, and upstairs neighbors who insist on wearing shoes in the apartment. After years of funding your landlord’s vacations, you’re ready to start putting money toward your own investment. That means thinking about homeownership. But what sort of a down payment do you need to get started? Many first-time buyers use a combination of a cash down payment and a mortgage to cover the cost of a home. How much you need to save for the down payment will depend on a few factors—and can have a big impact on how much you’ll end up paying over time. As you begin to think about your first mortgage, here are some important questions to ask yourself:
How much house can I afford?
The size of your down payment will be tied to the size of your mortgage, so let’s start there. The amount you’re able to borrow to purchase a home depends on your debt-to-income ratio, or DTI. This is the total amount you currently pay toward debt every month (you know, the bills you love seeing in your mailbox on a recurring basis—car payments, student loans, credit cards etc.) divided by your income before taxes. To get a Qualified Mortgage (QM), your DTI must be at or below 43%. Remember the housing crisis in 2008? QMs were created to prevent something like that from happening again by making lenders accountable for giving you a mortgage you can actually afford.
But just because you can technically afford a certain loan according to your lender doesn’t mean it’s the best fit for you. Instead of spending every dollar you’ve got on your mortgage each month, you want to make sure you have some left over to live a little. You can only have ramen noodles for dinner so many times. So when determining the magic number that will become your house-hunting budget, figure out how much mortgage you qualify for, and then how much you actually want to pay.
How much should I save for a down payment?
Now that you know how much you want your mortgage to be, use it to calculate the down payment. Conventional loans generally require buyers to put 20% down. That means if you’re looking to purchase a $200,000 home, you’ll need $40,000, plus money for the closing costs, which could range from 2 to 5 percent of the purchase price. So spelling out the math here—er calculating rather—that’s $4,000 to $10,000 for closing costs, or a max of $50,000 in cash due at closing.
A down payment of at least 20 percent could save you money over time. The larger the down payment, the less you have to borrow, and a lower LTV (loan-to-value of the house) ratio will help you qualify for a better mortgage interest rate.
What if I just don’t have 20 percent?
Don’t worry, you still have options to help get you into the house you want. Different types of mortgages accept smaller down payments. You can get a loan from the Federal Housing Administration (FHA) for as little as 3.5% down or a Department of Veterans Affairs loan with a zero down for qualified buyers. There are other programs out there, too.
Keep in mind that loans with a down payment of less than 20% require private mortgage insurance (PMI). PMI rates vary, but currently range between 0.3% and 1.2% of the loan amount on an annual basis. So assume you locked in a 30-year 4.5% fixed-rate mortgage for that $200,000 house you love. Your monthly mortgage payment alone would be $1,013. With less than 20 percent down and a PMI of 0.5%, you would pay an additional $83.33 each month, or about $1,000 per year. Not bad, considering that small extra cost could get you in a house of your own sooner rather than later. And you won’t have to pay that forever. In most cases, you can cancel your PMI once you have 20% equity in your home.
How can I save up?
However much you decide to put down, the earlier you start saving, the faster you’ll reach your goal. Sounds like something your parents would say, but that’s because it’s the plain old truth. Experts recommend a number of different strategies to put away money, but one of the easiest and most effective is to automate your savings with direct deposits from your paycheck into a designated account. Savers who "set it and forget it" rarely miss the money they put away (outta sight, outta mind kind of thing), and this can also help you get comfortable with living on less. Increase the amount of money you’re putting away by cutting expenses and selling items you no longer need. And be sure keep your savings in an interest-bearing account for an added boost.
You might also want to try "practicing" your intended mortgage payment. If you’re currently paying rent, deposit the additional amount you’d need to make your mortgage payment into your savings account each month. This will help you determine the amount you’re comfortable paying and how much house you can truly afford—not to mention padding your down payment savings at the same time. Homeownership, here you come.