You think you are ready to buy a home, but you are trying to decide what size down payment to make. There are many options out there depending on the type of loan you choose. Veterans can get 100% financing (make no down payment), buyers in rural areas can also get away with no down payment. FHA borrowers need at least 3.5% down and conventional borrowers need at least 5% down on a home.
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Just because these programs offer little to no down payment requirements, is it the right choice? Do you know what that smaller down payment costs you in the end?
Keep reading to find out.
A Higher Monthly Payment
First, the low down payment will increase your monthly payment. It’s like a tradeoff. You don’t put the money down now, but you have to pay it in your payment because you borrow more from the lender. If you want to keep your monthly costs down, it pays to make that larger down payment. The less you borrow, the lower your principal payments need to be each month. Plus, many lenders offer lower interest rates to borrowers that borrow less. The lower your loan-to-value ratio is, the lower the interest rate a bank may charge you. This can also help to decrease your monthly payment.
More Interest Paid Over the Life of the Loan
The more money you borrow from a bank, the more interest you will pay. If you calculate how much interest you will pay with a little down payment, you’ll see that borrowing that money, no matter how little, really adds up in the end.
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Let’s look at an example.
Let’s say you are buying a home for $200,000. You have $20,000 to put down on the home, but you are unsure about putting it all down. You are thinking about saving some of it in an emergency fund or to buy furniture for your home. Here’s how the different scenarios would add up in terms of total interest paid. We’ll use the same interest rate of 4% and a 30-year term for the sake of simplicity even though interest rates would likely vary between programs and LTVs.
- USDA or VA loan with 0% down – You would pay $143,739 in interest over the entire term
- FHA loan with 3.5% down – You would pay $138,708 in interest over the entire term. That’s a savings of $5,031 in interest for a down payment of $7,000.
- Conventional loan with 5% down – You would pay $136,552 in interest over the entire term. That’s a savings of $7,187 from the 0% down payment and $2,156 from the 3.5% down payment. You would put down $10,000 for the 5% down payment.
- Conventional loan with 20% down – You would pay $114,991 in interest over the entire term. That’s a savings of $28,748 from the 0% down payment and $23,717 from the 3.5% down payment.
As you can see, the larger the down payment, the more you save in interest. You have to decide at what point it makes sense to part with the large sum of money upfront and have the lower monthly payment. The larger your down payment becomes, the less interest you pay over the entire term of the loan. Of course, if you aren’t going to stay in the home for long, it may not make sense to part with your money upfront because you won’t be in the home long enough to save on the interest.
The Risk Lenders Take
Perhaps the largest issue with low down payments is the risk that lenders take. When lenders see that you are putting little of your own money down on a home, it sends up a red flag. Lenders need to protect themselves from default. When a borrower has a lot of their own money invested in a home, they are more likely to make their monthly payments on time. If a homebuyer borrowers most of the cost of the home, they don’t have as high of an incentive to make their payments on time.
When lenders feel like you are a high risk of default, they not only charge you higher interest rates, but they charge higher closing costs as well. Usually, this means they charge you an origination fee or ‘points’ on your loan. You’ll see the fee as 1%, 2%, or 3% of your loan amount. This means you’ll owe more for closing costs on your loan and not see any return in your home’s equity. You may be better off putting the money down on your home in the first place and being eligible for the lower closing costs.