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Many lenders make it easy to qualify for a mortgage to purchase a home even with a small down payment. But just because you can buy a home without putting much money down doesn't mean it's a good idea. In fact, the traditional recommendation is to put 20% down on your home. Following this old rule of thumb and waiting to buy until you've saved a full 20% of your home's price is often the best approach.
So, why shouldn't you jump in sooner and take advantage of lender programs that allow for low or no down payments? Here are three big reasons.
1. You'll have to pay for mortgage insurance
In almost all cases, you'll have to pay for mortgage insurance if you put less than 20% down. This could be private mortgage insurance (PMI) if you get a conventional loan not backed by the government. Or, if you qualify for a loan guaranteed by the Federal Housing Administration (FHA), it could be FHA mortgage insurance. While you don't have to pay for mortgage insurance with VA loans, you will have another up-front funding fee.
Mortgage insurance can be very expensive. The FHA charges both an up-front fee and ongoing premiums, and in some cases you're required to pay mortgage insurance premiums for the entire life of the loan. For conventional mortgages, PMI can sometimes be as high as 2.25%.
Mortgage insurance is designed to protect lenders. If they have to foreclose and your home sells for less than you owe, the insurance guarantees they won't incur outsized losses. You won't be protected against foreclosure by purchasing a mortgage insurance policy. You'll just face hundreds of dollars in extra costs each year for the entire time the insurance is required. This added expenditure makes your mortgage bill bigger without any benefit to you.
2. You may have to pay a higher interest rate
In many cases, lenders charge you a higher interest rate if you make a smaller down payment because they are taking on more risk by lending to you. You will, of course, also be borrowing a larger amount to buy your home without a down payment. This can mean you'll end up paying thousands of dollars in extra interest over the life of your loan -- because of both the higher rate and the larger principal balance.
3. You could easily end up underwater
A small down payment puts you at risk of owing more to your mortgage lender than your home is worth. This is called being underwater. It could happen if property values fall, or if they don't rise enough to pay off both your loan and all the costs associated with the sale of your home.
The last thing you want to do is end up owing more money than your home is worth. If you do that, you're going to face major challenges if you need to sell. You'd still have to pay off your loan in full, even if you couldn't get a high offer on the property to repay your loan and cover all closing costs. That would mean you'd have to bring money to the table to pay your lender back the difference between what you owe and what your home sells for.
For many people, it's impossible to come up with this extra cash. If this happens to you, you might not be able to sell your home when you need to. Or you may end up having to get your lender to agree to a short sale where they accept less than the balance due. This could seriously damage your credit.
If you're underwater, you probably aren't going to be able to refinance your loan either. This makes it harder to reduce your monthly payment or take advantage of low interest rates.
With a 20% down payment, you should have plenty of equity in your home to make the chances of ending up underwater slim. You also won't have to worry about getting stuck with a higher interest rate or PMI due to a low down payment. You'll be in a much better financial position, and buying your home will be less risky. It may seem hard to save up so much to buy a house, but it can be a much better choice than stretching to buy a home you can't really afford with a down payment that's too low.