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How Much Money Should You Put Down on a House?

March 4th, 2013 | Posted by JG in Getting Ahead | Investing

Buying a home can be time consuming and stressful, especially if it’s your first time.  One big decision is how much of your hard-earned cash should you put down all at once.  Since I’m in the middle of going through this process myself, hopefully I can provide a few helpful pointers on the Do’s and Don’ts.

money down on a home

What’s the point of putting money down?

For those just starting out on the home-buying journey let me explain a few basics.  Buying a house is typically made up of two components: the amount of cash you put in all at once and the amount of money that you borrow (i.e. your mortgage).  The more money you put down, the less money you have to borrow from the bank and usually the lower your interest rate.  Banks know that the type of person that makes a large down payment is also the type to pay their mortgage debt on time.  Your credit score is also a huge component of your interest rate, as it is a way lenders assess how “risky” you are as a borrower.  Check out my post on how to get and keep a good credit score.

So how much do you recommend?

At least 20%.  So if your house costs $250,000, you should put down $50,000 and borrow $200,000.  You’ll get a better interest rate and avoid having to pay for Private Mortgage Insurance (PMI) which is an additional monthly cost.  I explain PMI below.

I don’t have the 20%, what can I do?

Most homebuyers don’t have enough money to drop down 20% all at once.  As a result there are three common things you can do:

1)       Private Mortgage Insurance (PMI).  If you put down less than 20%, chances are you’ll have to pay this additional monthly insurance, which protects your bank or lender against you defaulting on your loan.  You have to pay this until you gain 20-25% equity in your home.  When this happens you typically have to pay to get your house re-appraised and then file a bunch of paperwork to get the PMI lifted.  I’ve heard that this can be a pain.

2)      Want to avoid paying PMI? Do an “80-10-10” loan.  This sounds complicated but don’t worry it’s not.  In this type of loan, you put 10% down in cash, you have a primary mortgage that covers 80% of the home, and you have a second (smaller) loan that covers the remaining 10%.  Keep in mind that this second loan carries a higher interest rate which you’ll want to pay down quickly.

You’ll have to crunch the numbers for yourself on which is best for you, but as a rule of thumb, if you expect the value of your home to increase faster than you’d be able to pay down the smaller, higher interest loan, then a PMI might make more sense than an 80-10-10.  If not, 80-10-10 might be a better option.

3) FHA Loans – These loans are backed by the federal government and allow those of more modest means to put as little as 3.5% down on a home.  These loans require FHA Mortgage Insurance for at least 5 years until the balance on your loan is down to 78% of the purchase price.  These loans also have strict limits.  In Houston, the loan limit is $271,050.  Check here to find FHA limits in your state.

In short, FHA loans are good if you have solid credit and less than 20% to put down.  These loans can be not-so-good because you’ll likely have a more expensive  interest rate,  you pay an FHA Mortgage Insurance premium both when you close on the home and every month for at least 5 years.

Check out this post on using money from your 401k to fund your down payment.

Prepare for a lot of closing costs and random fees

I thought I was the man because I had saved enough to put 20% down on a house and then I was introduced to the horrible world of closing costs.  In addition to the amount you plan on putting down, be prepared to spend thousands and thousands of dollars on closing costs, mortgage title fees, home inspections and random fees that no one can really explain, but you can’t avoid.  I don’t want to scare you, but make sure in addition to your 20% down, you have an extra few thousand to cover closing.  Typically, closing costs are about 2-3% of the cost of your loan.

Final thoughts

A large part of the financial crisis was caused by people taking out mortgages that they couldn’t afford.  While banks and lenders are doing a much better job at making lending practices more strict, I still see people biting off more than they can chew.  Here are a few things-to-remember from my perspective:

1)      Have your old paystubs, tax returns, W-2s, 401k and bank statements organized and ready to go.  When you meet with a lender, he or she will want to know all of the juicy details about how much you make, how much money you have saved, and how much you owe.

2)       Even if you’re married or engaged, don’t buy a house that you wouldn’t be able to pay for on your own.

3)      Don’t spend every dime you have buying a house.  It’s still important to maintain an emergency account and contribute to your 401k.

4)      Don’t buy a house that you can marginally afford on your current income and say “well I’ll get raises over time so it’ll become easier.”  Life also gets more expensive, often faster than your annual raises.

5)      A house is not a sign that you have “arrived” or that you’re a real grownup.  Many real adults have decided that renting works best for them and allows for greater flexibility if you plan on changing jobs frequently or moving away.

6)      You don’t need to buy all of your furniture all at once.  Get a piece every paycheck or every month.  Remember that maintaining a certain amount (at least 6-8 months of expenses) of cash savings is important.

7)      Except the fact that you’ll make lots of mistakes along the way.  It’s OK, life goes on, just try not to make the same ones over again.

What do you all think?

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~

JG

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4 Responses

  • Alison says:

    Not an expert on the home-buying stuff (yet), but might the closing costs be negotiable in that the seller could cover them rather than the buyer upon certain conditions? I’m not sure how often it happens if it does happen, but I imagine it would be a good strategy to use if you want to save a few thousand dollars.

  • Ben Dubiel says:

    Also, don’t be affraid of internet lenders. Look at Bankrate.com and go for the lowest rates in your area. These brokers will write your loan and most likely sell it to a larger bank that would have charged you an interest rate that is higher by 0.5% or more. Also, try to negotiate to have the seller pay the closing costs, fairly common over the past 3 years an some sellers may still be willing to do this to close the deal.

  • Diana Mobley says:

    Great article. I think a mention of points and origination fees would be helpful. Points and origination fees are a great way of comparing lenders, and these really can effect your amount due at closing by several percent. Using APR instead of interest rate is helpful in comparing lenders, but also determining if it is worth paying points (or taking negative points) or not can be stressful on its own.

    Alison, I believe sellers can give a credit to the buyer of up to 3% the loan amount at closing. These can be used to cover closing costs and repairs (and often 3% is sufficient to do so), but this credit cannot exceed 3%. In a seller-friendly market like trendy areas, sellers will be less likely to do this, but it can always be used in negotiation.

  • maurice says:

    Nice Article… When I closed, I was able to ask for 6% towards closing costs… maybe it varies by state/city.

    Also, it might be good to point out the “hidden” maintenance costs of home ownership. A lot of home owners will tell you that they spend X amount of dollars per year in maintenance. This could be replacing a water heater, having a gutter repaired, or painting your house. When people are looking into buying a house, they should make sure they have the cash to take care of emergencies that come up. This may require increasing the amount that they save.

    Keep up the good work.

    Maurice