Making a Home Down Payment Under 20%? Keep These 3 Factors in Mind

A home purchase is likely to be the biggest expense you'll ever have, and as such, it's worth taking the time to truly reckon with the costs you'll take on when you do. Along your journey to homeownership, the largest single cost you'll incur could well be your down payment.

It's a common misconception that you're required to save up 20% of a home's purchase price for a down payment. In reality, you might be able to pay as little as 3% down for a conventional mortgage loan or 3.5% for an FHA loan. If you qualify for a USDA or VA loan, you may not need a down payment at all to get into a house.

"Hooray!" you might be thinking. "A home can be mine for less than 20% down! Where do I sign?" Well, not so fast. There are a few things you should consider before making a smaller down payment on a home purchase.

1. Mortgage insurance will add to your costs

Putting less down for a home purchase can add to your ongoing costs in the form of mortgage insurance. This doesn't protect you as the borrower, but rather, it protects your mortgage lender if you default on the loan and the lender must reclaim your home and sell it, potentially at a loss. There are different types of mortgage insurance for low down payments.

If you opt to put less than 20% down on a conventional loan, you'll likely be charged for private mortgage insurance (PMI). This will generally amount to 0.5% to 1% annually of the amount you borrow. If you take out a mortgage loan for $250,000 and your PMI is 1% of that amount, you're looking at paying $2,500 per year, or an additional $208 per month on top of your regular mortgage payment. Your PMI can be canceled once you reach 20% equity in your home.

If you're buying with an FHA mortgage loan, you'll pay mortgage insurance premiums (MIP). These come in the form of a monthly cost as well as an upfront cost at closing. Unfortunately, unless you make at least a 10% down payment, MIP is with you for the life of the loan (with a 10% down payment, it lasts 11 years). You may be able to refinance into a conventional loan once you reach 20% equity, though. USDA mortgage loans have mortgage insurance, too, but the cost is generally less than on an FHA loan. Of course, these loans also have strict income requirements to qualify, and you must be buying a home in an eligible rural or suburban area.

2. With no down payment, you'll pay more for a VA loan, too

If you're an active duty service member or a veteran, you might qualify for a VA mortgage loan. For qualified buyers, these loans have no down payment requirement at all. However, you will not get away scott free, as there is a funding fee to contend with. The VA funding fee is calculated based on whether this is your first home loan with the VA and whether you make a down payment.

Let's say you're still borrowing $250,000 for a home and not making a down payment. It's your first VA loan purchase, and so you're assessed a 2.3% upfront funding fee. That comes to $5,750. If you made a 5% down payment and borrowed that $250,000 to cover the rest of your home purchase, your funding fee would be 1.6%, or $4,125. Even on a loan with no hard down payment requirement, you will still have to cough up extra funds.

3. A lack of equity can be problematic

No matter what kind of home loan you're getting, going in with a 20% down payment will help you get approved. Lenders like to see that you'll have "some skin in the game," so to speak -- meaning you stand to lose a chunk of money if you stop making mortgage payments and lose the house to foreclosure. And it's important to do whatever you can to reduce your mortgage costs, especially in this time of higher rates. As of this writing, the average rate on a 30-year fixed-rate loan is 6.81%, per Freddie Mac. With a down payment, your interest rate could be lower.

Plus, having little or no equity in your home increases the odds of ending up underwater on your mortgage loan. This is when you owe more on the home than what it's worth. Home values do fluctuate, and this might not be a big deal if you're not struggling to make payments and don't need to sell right away. But if you do need to sell and won't be able to command a high enough price to pay off your loan, that could be a real problem.

As you can see, making a lower down payment may save you money upfront, but it could cost you more in the course of buying a home. Be sure you've fully grasped these factors before proceeding with a down payment under 20%.