Tips for Making a Down-Payment

Determining the size of one’s down-payment is more complicated than it would seem. Historically, the prevailing wisdom regarding down-payments was the larger the better. During the inflating of the housing bubble, however, this logic was turned on its head, and it was even possible to take out a no-money down mortgage. As it turns out, there are advantages and disadvantages to both approaches.

Personal finance columnists usually advise a down-payment of 20% Loan-to-Value (LTV). In other words, take the size of your mortgage, multiple it by 20%, and VOILA, you have your down-payment. According to their reasoning, 20% is substantial enough both to demonstrate your creditworthiness to the lender and to cushion you from negative price swings in the value of your home.

Given the decline in housing prices, however, it’s perfectly conceivable that borrowers that made 20% down-payments are still underwater in their mortgages. After a foreclosure, then, such borrowers will be left with stains on their respective credit report, and gaping holes in their personal assets. From the lender’s perspective, meanwhile, such borrowers are actually considered less credit-worthy than those that make the minimum required down-payment. For those of you scratching your heads: It turns out that those who make down-payments between 20-25% are actually more likely to default. In addition, such borrowers aren’t required to purchase private mortgage insurance, further increasing the cost of default to the lender.

The cost of private insurance, then, can actually be recouped in the form of lower interest rates! In other words, there isn’t much of a financial penalty (sometimes even a reward!) for making a smaller down-payment. Some financial planners now encourage making the smallest allowable down-payment, based on the reasoning that borrowers can then set aside extra money in an emergency fund, making it less likely that they will become delinquent (miss payments) on their mortgage further down the road.

What is the minimum down-payment? Well, that depends on the loan, and the lender. A Federal Housing Administration (FHA) loan requires a 3.5% down-payment. [However, proposed legislation would increase this to 5%]. For veterans, or those that live in rural areas, there are VA home loans and Guaranteed Rural Development loans, respectively.

For those not eligible for the loans above, it might be worth looking into a down-payment assistance program. Some of these programs are also government sponsored, and/or provide low-interest loans to be used exclusively for making a down-payment. There are also several not-for-profit companies which offer down-payment assistance, typically by rolling the down-payment into the overall loan amount, but such organizations have come under scrutiny in the wake of the collapse of the housing market. For first time home-buyers, the $8,000 tax credit can now be “monetized” and applied towards the down-payment. [Under earlier rules, the credit was received in the form of a tax credit, and hence, could not used for a down-payment.]

For those still struggling to scrape together the cash, there are a few more options available to you. First, you can talk to your lender and try to pledge securities in lieu of making a down-payment, but be advised that such is tantamount to borrowing money to buy stock. Second, if you already own the land that your home is (being) built on, that may qualify as a down-payment. Third, you can appeal to family/friends for help, but be aware that the lender will demand proof that any such assistance is a gift, rather than a loan. Finally, you might try talking to the seller, and asking him to help you make your down payment (offset in the form of a higher sale price). This will only be possible, however, if the sale price initially exceeded the appraised value.

All else being equal, a larger down-payment should translate into smaller monthly payments, as a result of both lower principal and interest. It should also lower your mortgage insurance premiums. As I noted above, however, some lenders actually penalize those who make larger down-payments. Ultimately, every situation is different, and it probably makes sense to use calculators to crunch the numbers associated with a few different scenarios to see ultimately which one makes the most (financial) sense for you.