You've picked out the perfect home and you're ready to buy. Your credit is stellar and you know you won't have any trouble getting approved for a loan. But you don't have enough for a 20% down payment. Should you be worried?
Probably not. Despite what your mortgage lender would lead you to believe, making a smaller down payment can sometimes be the smart move. Below, I'll cover a few scenarios where you may want to consider putting less than 20% down, as well as a few reasons you may not want to do this.
Why 20% down is the gold standard
Mortgage lenders love large down payments because it lessens the risk for them. When you put 20% down, they're lending you less money, so if you fail to pay back what you owe, the blow won't be as severe as it would be if you'd only put 5% down.
If you're able to pay 20% up front, you're also more likely to get approved and you'll score better interest rates. A smaller borrowed amount and a lower interest rate can easily shave tens of thousands of dollars off your loan. Say you're buying a $200,000 home with a 30-year fixed-rate mortgage. If you put 20% down and you have a 4% interest rate, you'll pay $275,000 over the lifetime of the loan. If you put 5% down, your interest rate may be higher -- say, 4.25% -- and you'll have to borrow a larger sum. By the end of the 30 years, you'll have spent $336,000. And that's before we talk about PMI.
Any time you put less than 20% down on a home, you'll have to pay private mortgage insurance (PMI) until you reach 20% equity. PMI can vary anywhere from 0.3% to 1.5% of the original loan amount, depending on your credit score and the size of your down payment. Going back to the previous example, let's say you have to pay 0.75% extra each year for your PMI. That would cost you an extra $1,425 per year. You'd have to pay this for about eight years until you reached 20% equity, resulting in an extra $11,400 over the life of the loan.
If you don't want to pay too much money in interest and PMI, it makes sense to put down a 20% down payment if you can afford to do so. But there are times when it's smarter to hold on to your cash, even if it means higher mortgage payments.
When you shouldn't put 20% down
The main advantage of not putting 20% down is that you free up your cash to be used toward other things. If you're buying a fixer-upper, for example, making a smaller down payment enables you to use that cash for repairs and renovations to the home. Then, if you decide you'd like to get rid of your PMI down the road, you can refinance. If your upgrades increase the value of the home, you'll gain equity without having to put any more money down.
You may also want to keep your money liquid so you can put your cash toward other things, like saving for retirement. This is only a good idea if you can comfortably afford your home's mortgage payment with PMI. If that's straining your budget, you're better off putting your cash toward a down payment on your home. That way, your monthly payments will be lower and it will be easier to stay on top of them.
Another time when it's wise to stick with a lower down payment is if the homes in your area are appreciating rapidly. If that's the case, you'll probably build equity without having to do anything, so there's less incentive to put a lot of money down when you buy the home.
Finally, you may find yourself in a situation where you really want to buy a home, but simply can't afford a 20% down payment. As long as you can afford the monthly payments, there's no reason why you can't purchase a home with just a few percent down. But you'll have to be comfortable with the idea of paying a lot more in interest over the course of the loan.
A 20% down payment makes a lot of sense for some homebuyers, but not as much for others. Consider how much money you can reasonably afford to put down on a home and how that will impact your monthly payments. Play around with the numbers as needed until you find a solution that strikes the best balance between equity and liquidity.