Is It Really So Bad to Buy a House With a Small Down Payment?

You may be surprised at the answer.

When you apply for a mortgage to purchase a home, you will need to make at least some type of down payment with most -- but not all -- loans. The gold standard for home down payments is 20%, and there are huge advantages to putting so much money down when purchasing a property.

The problem, however, is that saving up to put down 20% of what a home costs can be a major financial challenge -- especially in housing markets where properties tend to be very expensive.

If you find yourself wanting to become a homeowner but are far short of the down payment, you'll want to think carefully about the pros and cons of a smaller deposit on a property, so you can make an informed choice about whether it's a good or bad idea to buy a home with less money down.

The biggest downsides of buying a home with a small down payment

There are considerable disadvantages of purchasing a property and not putting much money down. Here are some of the reasons why making a small down payment can end up costing you:

• You'll likely have to pay for mortgage insurance. Mortgage insurance is a type of protection for the lender in small down payment loans. The policies ensure the lender doesn't end up with losses that aren't repaid if they have to foreclose on your property because you default. You don't get protection from foreclosure -- the lender can still take your house -- but you do get stuck paying the premiums for the protection. This can come at a substantial cost, often equaling around 1% of your loan amount.
• Your choice of lenders may be limited. Not all lenders offer loans with lower down payments. You may have to choose one that provides government-backed loans, such as FHA loans, or that has a low down payment or first-time buyer program.
• Your interest rate may be higher. Since you don't have as much money on the line, the lender's risk is greater so it’ll likely charge you a higher interest rate.
• You could end up underwater. If you owe more than your house is worth, you're said to be underwater on the loan. This could easily happen if you make a small down payment and then there's any decline in property values in your area. If you're underwater, you couldn't sell without coming up with extra cash to pay the loan (at least not without damaging your credit). You also couldn't refinance if needed.

These downsides underscore the risks of small down payment loans and show why you should be cautious about buying if you can't put down at least 20%.

Should you steer clear of buying until you can put 20% down?

As you can see, there are some pretty significant disadvantages to purchasing a home and putting less than 20% down. But this doesn't mean it's always a bad financial decision or the wrong move.

If it would take you many, many years to amass a 20% down payment and you live in a market where property values are rapidly rising, it may not make sense to wait. You could miss out on potential appreciation of your property and end up worse off -- or not being able to afford a home even in the future as prices keep rising.

Likewise, if renting is much more expensive where you live, then you could end up wasting money by paying rent rather than just buying a home with less down.

The key is to assess your financial situation carefully. If you can still qualify for a competitive mortgage rate with a low down payment; if you're otherwise in a good financial position to buy; and if you aren't stretching yourself too thin with your housing payment, then it may not be such a bad thing to buy a home even if you can't put much of a deposit down.

By considering the overall affordability of the home and making sure you're ready to move forward with a purchase, you can make the best choice about whether buying with a small down payment is right for you.