The 20 percent solution
Ideally, when buying a home you should have enough money accumulated for a down payment of 20 percent of the property’s purchase price. Why 20 percent and not 10 or 15 or 25 or 30 percent? Twenty percent down is the magic number because it’s generally a big enough cushion to protect lenders from default. Suppose, for example, that a buyer puts only 10 percent down, property values drop 5 percent, and the buyer defaults on the loan. When the lender forecloses — after paying a real estate commission, transfer tax, and other expenses of sale — the lender will be in the hole. Lenders don’t like losing money. They’ve found that they’re far less likely to lose money on mortgages where the borrower has put up a down payment of at least 20 percent of the property’s value. (Unfortunately, lenders and the folks in Washington forgot this fact, which led to the late 2000s real estate market problems and high levels of foreclosures.)
If, like most people, you plan to borrow money from a bank or other mortgage lender, be aware that almost all require you to obtain (and pay for) private mortgage insurance (PMI) if your down payment is less than 20 percent of the property’s purchase price. Although PMI typically adds several hundred dollars annually to your loan’s cost, it protects the lender financially if you default. Should you buy an expensive home — into the hundreds-of-thousands-of-dollars price range — PMI can add $1,000 or more, annually, to your mortgage bill. (When you make a down payment of less than 20 percent, you can also expect worse loan terms, such as higher up-front fees and/or a higher ongoing interest rate on a mortgage.)
Note: If you have (or expect to have) the 20 percent down payment and enough money for the closing costs, skip the next section and go to the section on how to invest your down-payment money.
Ways to buy with less money down
Especially if you’re just starting to save or are still paying off student loans or worse — digging out from consumer debt — saving 20 percent of a property’s purchase price as a down payment plus closing costs can seem like a financial mountain.
Don’t panic, and don’t give up. Here’s a grab bag filled with time-tested ways to overcome this seemingly gargantuan obstacle:
Boost your savings rate. Say that you want to accumulate $30,000 for your home purchase, and you’re saving just $100 per month. At this rate, it will take you nearly two decades to reach your savings goal! However, if you can boost your savings rate by $300 per month, you should reach your goal in about five years. Being efficient with your spending is always a good financial habit, but saving faster is a necessity for nearly all prospective home buyers. Without benevolent, loaded relatives or other sources for a financial windfall, you’re going to need to accumulate money the old-fashioned way that millions of other home buyers have done in the past: by gradually saving it. Most people have fat in their budgets. Start by reading Chapter 2 for ways to assess your current spending and boost your savings rate.
Set your sights lower. Twenty percent of a big number is a big number, so it stands to reason that 20 percent of a smaller number is a smaller number. If the down payment and closing costs needed to purchase a $300,000 home are stretching you, scale back to a $240,000 or $200,000 home, which should slash your required cash for the home purchase by about 20 to 33 percent.
Check out low-down-payment loan programs. Some lenders offer low-down-payment mortgage programs where you can put down, say, 10 percent of the purchase price. To qualify for such programs, you generally must have excellent credit, have two to three months’ worth of reserves for your housing expenses, and purchase private mortgage insurance (PMI). In addition to the extra expense of PMI, expect to get worse loan terms — higher interest rates and more up-front fees — with such low-money-down loans. Check with local lenders and real estate agents in your area. The best low-down-payment loan is the FHA purchase program. If you are a veteran, get a VA loan. Unless you’re chomping at the bit to purchase a home, take more time and try to accumulate a larger down payment. However, if you’re the type of person who has trouble saving and may never save a 20 percent down payment, buying with less money down may be your best option. In this situation, be sure to shop around for the best loan terms.
Access retirement accounts. Some employers allow you to borrow against your retirement-savings plan. Just be sure you understand the repayment rules so you don’t get tripped up and forced to treat the withdrawal as a taxable distribution. You’re allowed to make penalty-free withdrawals from Individual Retirement Accounts for a first-time home purchase (see Chapter 2).
Get family help. Your folks or grandparents may like, perhaps even love, to help you with the down payment and closing costs for your dream home. Why would they do that? Well, perhaps they had financial assistance from family when they bought a home, way back when. Another possibility is that they have more money accumulated for their future and retirement than they may need. If they have substantial assets, holding onto all these assets until their death can trigger estate or inheritance taxes depending upon the state they live in. A final reason they may be willing to lend you money is that they’re bank-and-bond-type investors and are earning paltry returns. If your parents or grandparents (or other family members, for that matter) broach the topic of giving or lending you money for a home purchase, go ahead and discuss the matter. But in many situations, you (as the prospective home buyer) may need to raise the issue first. Some parents just aren’t comfortable bringing up the topic of money or may be worried that you’ll take their offer in the wrong way.
Look into seller financing. Some sellers don’t need all the cash from the sale of their property when the transaction closes escrow. These sellers may be willing to offer you a second mortgage to help you buy their property. In fact, they often advertise that they’re willing to assist with financing. Seller financing is usually due and payable in five to ten years. This gives you time to build up equity or save enough to refinance into a new, larger, 80 percent conventional mortgage before the seller’s loan comes due. Be cautious about seller financing. Some sellers who offer property with built-in financing are trying to dump a house that has major defects. It’s also possible that the house may be priced far above its fair market value. Before accepting seller financing, make sure the property doesn’t have fatal flaws (have a thorough inspection conducted, as we discuss in Chapter 13) and is priced competitively. Also be sure that the seller financing interest rate is as low as or lower than the rate you can obtain through a traditional mortgage lender.
Get partners. With many things in life, there is strength in numbers. You may be able to get more home for your money and may need to come up with less up-front cash if you find partners for a multiunit real estate purchase. For example, you can find one or two other partners and go in together to purchase a duplex or triplex. Before you go into a partnership to buy a building, be sure to consider all the “what ifs.” What if one of you wants out after a year? What if one of you fails to pay the pro-rata share of expenses? What if one of you wants to remodel and the other doesn’t? And so forth. Have a lawyer prepare a co-ownership agreement that explicitly delineates how issues like these will be dealt with. Otherwise, you can face some major disagreements down the road, even if you go in together with friends or people you think you know well. We cover the pros and cons of partnerships in Chapter 8.