Does Having a Small Down Payment Mean You Aren't Ready to Buy a House?

Since 2018, the typical first-time home buyer has made a down payment of around 6% to 7% of the value of the house they are purchasing, according to the National Association of Realtors. This is below the 20% down payment that is usually recommended and that is required to avoid having to buy private mortgage insurance. Mortgage lenders require PMI on loans with less down because it protects them against losses in case they have to foreclose -- but you have to pay for that protection.

So if you have only a little bit of money in your checking account to put down, does this mean you're not ready to buy a house? Here's what you need to know.

A small down payment could come with added costs

One of the biggest downsides of having a small down payment is that you'll have added costs to pay.

As mentioned above, you'll need to buy private mortgage insurance (PMI) if you put less than 20% down. Typically, PMI costs between 0.2% and 2% of the amount of your loan each year. So if you borrow $400,000, you'd be paying between $800 and $8,000 a year in PMI.

You will also be borrowing more with a smaller down payment, so your monthly payment (and interest costs) will be higher due to the fact you have a larger loan balance. This is on top of the added cost of PMI. You may also have to pay a higher interest rate since you could have fewer options for lenders. Not all lenders accept low down payments (and lenders who do often charge higher rates since they're taking on added risks due to your small down payment).

Let's say you're buying a house valued at $450,000. Here's how different the payment could look with a 20% down payment versus a 5% down payment:

As you can see, you'll typically pay a lot more each month for your loan if you have a smaller down payment.

You risk ending up owing more than the house is worth

There's another big downside to making a small down payment: You could end up without much equity in your house to start, so you could find yourself owing more than the house is worth. This is also called being underwater on your loan.

Generally, you don't pay down much of your loan balance early on, since much of your mortgage payment goes towards interest. After a year of making payments on a $427,500 loan at 7.50% down, you would still owe $423,559.16. If property values declined even a little bit, you could end up owing more than the house is worth.

And since closing costs for sellers can equal around 6% to 10% of the home's value, you'd almost assuredly owe more than you could sell the house for. This can make it impossible to move or refinance your loan if you need to.

You may be unprepared for emergencies

Finally, if you have a very small down payment, chances are you also won't have a ton of money set aside for emergency expenses. Unfortunately, owning a home can come with a lot of added costs, such as maintenance and repairs. And if you lose your job or experience an income reduction, you'd still have the mortgage to pay.

If you have a small down payment and no emergency fund, you're taking on a really huge risk and probably aren't ready to make a home purchase.

Does this mean you shouldn't move forward?

Now, there are clearly some huge downsides to having a small down payment and buying a house. But there's an upside, too: You get into the house. You can start building equity and benefiting from property appreciation. If you had to wait months or years to save up more money, property values could go up in the meantime and you could still end up priced out.

Before you move forward, though, you do want to make sure that your monthly payments -- including PMI -- are affordable, that you don't have plans to move or refinance for a while (in case you end up owing more than the home's value for a period of time) and that you have money for emergencies. If all those things are true, then buying a house with a small down payment may be an OK choice.