Owning a home has long been the American Dream, but attaining that dream often hinges on one key thing: coming up with a down payment. You'll often be required to put down at least 20% of your home's purchase price to get approved for a mortgage, but that's not always true. If your credit is solid, you might get away with putting down far less on a home -- something buyers have been taking advantage of lately.
An estimated 54% of Americans put down 10% or less on a new home purchase, while 36% put down 5% or less, according to new data from COUNTRY Financial. While that might seem like a reasonable solution to the absence of available funds for a down payment, it's a move that could end up hurting you in the end. Here's why.
1. You'll add to the cost of your loan
If you take out a conventional loan and put down less than 20% on your home, your lender will require private mortgage insurance, or PMI. This insurance isn't for your benefit. Rather, it's for your lender's benefit so that if you're unable to make a payment, your lender has some protection.
The problem with PMI is that it can be costly. In fact, it can easily equal up to 1% of your loan value so that if you take out a $400,000 mortgage, you'll be on the hook for an extra $4,000 a year on top of your regular mortgage payment. Furthermore, you'll be liable for PMI until you manage to build 20% equity in your home.
2. You'll have less equity to tap
One benefit of owning a home is that you can use its equity to access money when you need it, whether to make repairs or improvements to that property or for another purpose. Equity is the portion of your home that you actually own, or the difference between your home's market value and the amount you owe on your mortgage. For example, if you put down $20,000 on a $200,000 home, you'll have 10% equity.
You can tap your home equity in two ways: by obtaining a home equity loan or getting a home equity line of credit. Neither option, however, is available when you don't have enough equity in your home to qualify for the financing you're looking for.
3. You'll risk getting underwater on your mortgage
The value of your home plays a large role in determining how much equity you have in it. But what happens if your home's value suddenly drops due to, say, poor market conditions? If you don't have a lot of equity to begin with, you might encounter a scenario where you're underwater on your mortgage -- meaning you owe more on your home than its total value.
If that happens, but you're not planning to move and are able to keep up with your mortgage payments, you won't necessarily get hurt and can just ride out that market dip until your home's value comes back up. But if your circumstances change -- say you get a new job elsewhere or lose your job and can no longer make mortgage payments -- you'll be in trouble because if you sell, you'll end up owing your lender money at the end of the day.
If you're short on cash but don't want to delay homeownership, putting down a smaller payment might seem like a smart move. And in some cases, it can very well work out. Just be aware of the pitfalls involved before going that route and consider the benefits of waiting just a bit longer to buy.
Postponing that goal by a year, for example, gives you more time to cut back on spending, work a side job, or employ other creative means of scrounging up cash. And that's something you might really appreciate once you do become a homeowner.