Okay, for YEARS I have been pitching the idea that before buying a house you should save up a 20% down payment. A 20% down payment means that you avoid paying PMI and are not forced to do escrow for property taxes and insurance. By saving up 20% you also demonstrate to yourself and the bank that you are capable of running a budget surplus and starting out with 20% ownership in the house greatly reduces the odds of your home becoming upside down. Whenever I have this discussion with anxious potential home buyers, most feel like I am setting unrealistic goals when requiring a 20% down payment. FHA loans require a minimum of 3.5% down, and VA loans can be had with 0% down. With these factors many people will go ahead and buy a house without 20% down, for these people there a few things to do to minimize the negative impacts of a low down payment.
Rules To Buying A House Without 20% Down
I have always said that buying a house when you have no money will make you poor, and this is true, you know what else will make you poor? paying twice in rent what it would cost you to own every month, forever. That is certainly a recipe for poverty, and what motivated me to buy my first home when I was 20 in Benton Harbor, MI for $48,500 (with 20% down). It is possible to own a home in Benton Harbor, MI for $320 per month with 20% down, and the same house would rent for $600 per month. If you must buy a house without putting 20% down, follow these guidelines:
Rule #1: Only buy a modest house that the monthly cost is under 25% of your gross income. You should also have 2 years of stable job history.
Rule #2: Get a 15 year mortgage: Putting down 3.5% and getting a 15 year mortgage is often better for you financially than putting down 20% and getting a 30 year mortgage. A big reason for going with a 15 year instead of a 30 year when forgoing a 20% down payment is the quicker reduction in PMI. A 15 year mortgage will reach 20% equity about 5 years sooner than a 30 year mortgage.
Rule #3: Have cash reserves of at least $2,000 to cushion any emergencies that may come up directly after closing on the house.
Example: Buying A House With 3.5% Down
Home Price: $40,000
- Down Payment 3.5%: $1,400
- Closing costs: $2,000: Negotiated $1,000 paid by sellers, $1,000 by buyers, includes 175 upfront basis points for PMI ($675).
- Cash out of pocket: $2,400
- Total Loan amount: $38,600
- 15 Yr Loan at 3.5% = $276 per month
- House Insurance: $40 per month
- Property Taxes: $70 per month
- PMI 70 Basis points: $23 per month
- TOTAL Payment: $409 per month
Following rule #1, to buy a $40,000 home your income would need to be 4 times $409; $1,630 per month. At 40 hours per week, this works out to just over $10 per hour for 1 person.
Following rule #2, At 39 months your loan will drop below $32,000, at which point you will have 20% equity and no longer need PMI, this will cut your payment down to $386. On a 30 year mortgage this wouldn’t happen until month 104! That’s $1,500 thrown away on PMI! 5 years into the loan you would only owe $27,700 and at 10 years you would only owe $15,000.
A buyer purchasing a $40,000 home with 3.5% down on a 15 year mortgage would have more equity in the house 5 years into the loan than a buyer who paid $40,000 for a home with 20% down on a 30 year loan. A 15 year mortgage is a powerful thing!
The total payment of $409 per month is about $200 per month less than what the same house would cost to rent. Home repairs can certainly cut into this savings and there may be some years where the $2,400 difference is completely spent on home repairs, but the big difference is it is yours and you are building equity every month. Those repairs preserve your equity and the upgrades will increase it.
Following rule #3, the person buying this home would have $4,400 in cash before going through with the loan. This leaves $2,000 to cover any immediate emergencies following the home purchase.
Beware of Hidden Costs:
FHA loans require the house to meet certain requirements before you can purchase it. If an FHA inspector says a railing needs to be put up, a window needs to be replaced, or GFCI outlets be installed, you may have to bear the costs of this work up front before purchasing the home. Also, talk to multiple lenders to cost compare closing costs. When shopping for a loan I have seen closing costs for the exact same loan terms vary from $1,500 to $5,000.
VA Loans that are a benefit to America’s veterans offer 0% down loans, however the buyer must pay a fee of 2.15% of the loan. On a $40,000 property, this would be $816, and unlike a down payment, this money doesn’t build any equity it the home, it just vanishes.
Rural Development Loans also come with large up front closing costs in lieu of a down payment. Essentially you are paying for insurance for the bank in case you default, since putting no money down makes you a much greater default risk. When Mrs. C. and I went to buy our home for $145,000 closing costs on the rural development loan our realtor was discussing with us were around $7,000, compared to the $1,500 in closing costs we had getting a 30 year loan with 20% down.
Research Federal, State, and Local Home Buyer Programs
The Fannie Mae HomePath program will provide up to 3% of the price of the home towards closing costs for first time home buyers who complete a short home buying course, meet certain requirements and are purchasing select HomePath properties that are bank owned. In our above example this would be $1,200 towards closing costs, reducing cash out of pocket for our buyer from $2,400 to $1,200. That’s a pretty darn good deal if you ask me. As with most programs for first time home buyers, it doesn’t really mean first time home buyers. As long as you haven’t owned your own home in the last 3 years you can qualify as a first time home buyer.
One of the best aspects of this program is the “First Look” aspect, which allows buyers who will be owner occupants a 20 day window to make an offer on the property before any investors will be considered. This takes a lot of the competition for homes out of the water.
MI First Home: In my article on Buying A House In Benton Harbor, MI I discussed a set of programs in Michigan called MI First Home and My Next Home offering up to 4% down payment assistance for home buyers in select parts of Michigan. The buyer must meet income, asset, and credit score guidelines, but overall this seems like a great way to get into a home if you are having trouble saving up the cash. The assistance does have to be paid back, and it is seen as a “soft second loan”. 0% interest is charged on it, no payments have to be made, and it doesn’t have to be paid back until the house is sold or the buyer refinances.
In our example of a $40,000 home purchase, this would mean a maximum credit of $1,600 to go towards the down payment and closing costs. Following our example, cash out of pocket for the buyer could then be only $800. What this program essential does is removes the need for buyers to save up for a down payment on an FHA loan and covers a bit of the closing costs as well.
I believe that it is best to buy a home with a 20% down payment, but I also accept the reality that most home buyers are not going to do this. I wrote this article for those buyers and hope that they will take this advice. The programs outlined above remove substantial barriers to entry in the housing market and can help some people achieve the American Dream much sooner than they could without them. If buyers insist on getting a modest home on a 15 year mortgage then I think these ways of financing a home are a smart way to go. Check out Lending Tree for current interest rates.
What do you think about FHA loans? Does it make sense if you can’t put 20% down to at least insist on a 15 year mortgage?