The Down Payment
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Nobody pays cash for a
house. Instead, you pay for most or all of it by getting a
loan from a bank, called a mortgage. You will also probably
make a down payment of 3 to 20% of the sale price, though
sometimes it's possible to pay nothing down. Since everybody wants to
know how to get a house with zero down, we'll cover that first.
No-money-down loans
You can probably get a Zero Down Payment loan if your
credit score is excellent (~700+). If you qualify for a VA
(veterans) loan, you might be able to get by with a slightly lower
credit score.
No-money-down loans loans surged in popularity in the
2000's, going from 4.5% of loans in California to 20% from 2000 to 2007.
(HGTV)
Among first-time homebuyers the figure was even higher, with a
whopping 43% of them paying nothing down in 2006, up from 28% just two
years prior to that. (Washington Post) But banks got burned on these loans because
people who couldn't scrounge up a down payment were more likely to
default on their loans (duh), which is part of what caused the mortgage
lending crisis. (See sidebar.) So today banks require a higher
credit score than in the past for Zero-Down loans. If you're a veteran,
your chances of getting a no-money-down loan are greater since there
are special VA loans.
The Subprime Lending Crisis
Here's what happened in a nutshell: Subprime
basically means "bad credit", so a subprime loan is a loan made to
someone with bad credit. Lenders gave these out like candy from about
2000-2006. And of course, people with bad credit are more likely to
fail to make their payments and have their houses repossessed by the
bank ("foreclosed"). When a bank forecloses on a house it then sells
the house to get back the money they loaned out for it to be bought in
the first place. But wait! The real estate market took a dip in 2006,
so those repossessed houses were suddenly worth a lot less. So a bank
might have loaned out $200,000 on a house, but was only able to sell it
for $180,000. Uh-oh. Multiply this by thousands of homes, and you can
see that lenders lost a lot of money. Ta-Da! That's the Subprime
Lending Crisis. Lots of these subprime lenders went bankrupt. One of
the casualties was New Century Mortgage, a huge lender with nearly $2 billion
in markket capitalization, and which had actually handled the loan on
one of my homes. (Not that I got a subprime loan -- my credit is
excellent. New Century handled regular loans too.)
As a result of this subprime mess, it's now a lot harder
for subprime borrowers to get loans. Lenders are being a lot more
careful about whom they lend to.
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But this begs the question: Should you get a zero percent
down loan just because you can? Not necessarily. Here are reasons
to think twice about getting a 0% down loan:
- More likely to lose your home. If you can't make a
down payment it's either because you didn't have the financial
discipline to save, or you're not making enough money. Either of those
things makes it more likely that you won't be able to make the payments
on your house, and that you'll get foreclosed on and lose your house. A
study in Denver showed that over half
of foreclosures involved nothing-down loans. Ouch.
- Higher monthly payments. The less money you put
down, the more you're borrowing. And the more you're borrowing, the
higher your monthly payments.
- Nothing down means a smaller home. The less you put
down, the less the bank is willing to loan you. That means your options
will be more limited as far as what homes you can buy. With a down
payment -- any down payment -- you can get a bigger loan, and are more
likely to be able to get the home you really want.
- Harder to find the loan. No-money-down loans are
harder to find than something-down loans, which are ubiquitous.
- Harder to qualify. It's harder to get a bank to give
you a no-money-down loan than a loan where you put anything down.
- Private Mortgage Insurance. If you put nothing down
on a conventional loan, you'll have to pay for private
mortgage insurance. Actually, you'll pay this for any down payment
less than 20%, but the less you put down, the more the PMI, and the
longer you have to pay it.
So I encourage you to put down at least 5% if you can. I'm not
saying that you should never pursue a zero-down loan, but if you get
one just make damn sure you can afford it!
80/20 Loans
Often if you're able to put 0% down, then it works
just like you expect: You get a single loan for 100% of the
purchase price. But sometimes your lender or broker will offer you an
80/20 deal, where you get one loan for 80% of the price, and another
for 20% of the price. Why on earth would they do that, rather than
keeping it simple? Because it's typical for the 20% loan to carry a
higher interest rate, which makes more money for the bank.
But there's an advantage for you: With a 100% loan you
usually have to pay for private
mortgage insurance (PMI), while with an 80/20 loan you usually
don't.
So which is better? It's different for each situation. For
an apples to apples comparison, you need to find the total monthly
payments, including PMI, for each loan deal you're offered, over the
life of the loans.
Don't plan on borrowing the down
payment from relatives
The down payment has to be your money.
Why? Because when the bank gives you the main loan on your house,
they've calculated that you won't be able to pay back your loan if you
take on additional debt, and borrowing the down payment is additional
debt. Also, if you don't make your payments and they have to repossess
the house and sell it, they'll often want to sell it for less than it's
worth so they can sell quickly, and your down payment prevents them
from having a loss if they do that.
But what if someone gives you the money for a
down payment (your parents, maybe)? That's okay as long as you get
an FHA
loan, but not if you get a conventional loan. (Realize though that
many sellers won't agree to an FHA loan because it sometimes adds a
little red tape and because the inspectors are more strict about the
condition the house has to be in before it can be sold.)
Should you use your free cash to make a
bigger down payment or to pay down debt?
A very common question among homebuyers is,
"Should I use my extra cash to pay down my credit card debt, or should
I save it all for the down payment?" That requires a detailed answer,
so just for you, I've written a
detailed answer.
How big a down payment should you make?
If you can afford to put 20% down, you should.
You'll get a better interest rate, won't have to pay for private
mortgage insurance, will qualify for a larger loan, and will save a
bundle on interest.
In fact, if you can afford it, there's nothing wrong with
putting down more than 20%, as long as you still have enough
free cash on hand for emergencies. Remember, once you put money into
your house, it's not easy to get it back out, so keep that in mind
before you deplete your emergency savings.
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