Down Payment Hysteria

Posted: Updated:
Elaine Bedel established Bedel Financial in 1989 in Indianapolis. Elaine Bedel established Bedel Financial in 1989 in Indianapolis.

There are two words that will send chills down the spine of any potential homebuyer: down payment. Coming up with enough cash for a down payment is the single greatest roadblock for prospective homebuyers. What are the options and tradeoffs?

A down payment is key to determining the terms of a mortgage, but what if accumulating a down payment is a barrier to owning a home. If the borrower qualifies and/or meets the eligibility requirements, there are several government programs that may be helpful. However, some drawbacks may exist. 

Conventional Mortgage

The standard down payment for a conventional loan is 20 percent (for instance, $70,000 on a $350,000 house). So what are the benefits of such a large upfront financial outlay? Lenders dictate the terms of mortgages based on the perceived risk of the borrower. The ability to put down 20 percent, among other things, provides some assurance as to the financial health of the borrower. Therefore, the lender will likely offer more favorable terms.

The resulting benefits include:  

  • Improved chance of actually get the mortgage.
  • Smaller monthly payment.
  • Lower interest rate, resulting in substantially lower costs over the life of the loan.
  • No private mortgage insurance.

Down Payment Less than 20 percent: There is one big caveat when it comes to making a down payment of less than 20 percent. It’s mortgage insurance.  In addition to potentially being charged a higher interest rate, borrowers may be required to pay for insurance that protects the lender in the event of a default.

Like other forms of insurance, mortgage insurance is paid for with a premium that is simply added to the monthly mortgage payment. The cost typically ranges anywhere between 0.4 percent and 1.5 percent of the original loan amount at closing. For example, a $250,000 mortgage may include an additional $1,000 to $3,000 in annual costs.  Private mortgage insurance is only required until the borrower’s equity in the home is 20 percent or more.   

FHA Mortgage Loans

An FHA Loan is a mortgage that is insured by the Federal Housing Administration , which is part of the Department of Housing and Urban Development. With an FHA loan, the government guarantees that the bank is paid back in the event that the borrower defaults and, therefore, private mortgage insurance is not required. For this reason, the bank is willing to lend to individuals that generally do not meet all the requirements to obtain a conventional mortgage, such as lower credit scores, lower income, or a higher debt to income ratio.

The minimum down payment for an FHA loan is just 3.5 percent of the home’s purchase price. That means for a $350,000 home, the down payment would be $12,250. This is substantially less than the $70,000 (20 percent) required for a conventional loan. However, the FHA does collect an upfront fee of 1.75 percent of the mortgage amount plus a small on-going fee that is included in the monthly mortgage payment.

VA Mortgage Loans

VA loans, which are guaranteed by the U.S. Department of Veteran Affairs, allow for the buyer to purchase a home with no down payment and no private mortgage insurance. This type of mortgage loan is available to active-duty military personnel, U.S. military veterans, and surviving spouses. Similar to FHA loans, VA loans are provided through banks or other private lenders. Since the VA guarantees a portion of the loan, the lender can provide more favorable terms. To be eligible, the borrower must have a satisfactory credit rating and sufficient income to meet all monthly obligations.

The Doctor Loans - an Exception

Doctors fresh out of medical school are strapped with large amounts of debt and no proven ability to generate income. However, because of their high earning potential and their low probability of default (historically 0.2 percent), institutions will lend to new and established doctors under very favorable terms, requiring as little as 0 percent to 5 percent down payment and no mortgage insurance.

Summary

A mortgage is a long-term obligation and getting appropriate terms can make a difference in the total cost of purchasing a home. If accumulating a down payment is overwhelming, options may exist. However, be sure to do your homework, determine your qualifications, and understand the tradeoffs before signing the paperwork. 

Contributions were made to this article for Brian Rykovich, a Wealth Advisor at Bedel Financial Consulting, Inc.

Elaine E. Bedel, CFP, is President and CEO of Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. She is a featured guest each Wednesday on the WTHR (NBC, Indianapolis) Channel 13 News at Noon, "Your Money" segment. Elaine's book, "Advice You Never Asked For... But wished you had," is available on Amazon.com. For more information, visit www.BedelFinancial.com or email Elaine at ebedel@bedelfinancial.com.