Down-Payment: 20% is the Benchmark

One of the aspects of mortgage lending that has changed the most in the wake of the housing bust is the down-payment. At the height of the boom, it looked like down-payments could soon become, well, if not extinct, than at least irrelevant. Nowadays, a sizable down-payment is not only essential to getting a loan with good terms, but also to getting approved for the loan in the first place.

The current benchmark for down-payment is 20% LTV. That means you are expected to pay 20% of the price of the property in cash, with the mortgage covering the remaining 80%. For those of you who can afford to make such a down-payment, statistics show that you will be comparatively likely to repay your mortgage. Thus, you can expect to receive extremely favorable terms on your mortgage.

The primary source of funds for this down-payment will probably be your own savings account. In some cases, you can also pledge securities (stocks, bonds, etc.) and the land that the property occupies assuming that you already own it. Lenders will also allow you to borrow against your retirement account (though in some cases this must first be approved by the administrator of your IRA) as well as to contribute gifted funds from family/friends, as long as the giver signs an affidavit pledging that the gift is not actually a loan.

If the target property was appraised for more than the purchase price, however, you cannot contribute the difference towards the down-payment, even though it is arguably equivalent to home equity. The only exception is if the seller is willing to raise the purchase price and contribute (most of) the difference to your down-payment for the loan. Such is perfectly legal and is known as a Seller-Assisted Down Payment. Bear in mind, however, that if the purchase price is raised to the point that it exceeds the appraised value of the property, this kind of arrangement will probably be rejected by your lender.

If you can afford to do so, you should consider making an even larger down-payment. Some lenders will compensate you by offering you an even more attractive mortgage rate. In addition, a larger down-payment combined with a shorter duration (i.e. 20 years instead of 30 years), would enable you to own your home in a shorter amount of time and save you money in the process (in the form of unpaid interest), all without affecting your monthly payment. If instead you were to continue to prefer a long-duration (30 years) mortgage, you can count on both a lower monthly payment and aggregate savings over the life of the mortgage.

For those borrowers that can’t afford – or simply don’t want – to make a 20% down-payment, you have a few options. First, you can apply to a Down Payment Assistance Program (DPAP); it’s advisable to ask your lender for advice, rather than solicit help on your own. If you’re eligible, you can consider a Veterans Administration (VA) loan, most of which don’t require down-payments. FHA Loans are also insured by (but not originated by) the government, and hence, require only 3.5% down-payments. This is offset by a more expensive loan, however, in the form a mortgage insurance premium, payable to the FHA to compensate for the increased likelihood of default.

For everyone else, you can expect to pay a hefty Private Mortgage Insurance (PMI) premium. Assuming your lender is still willing to underwrite your loan, despite a down payment that is below 20%, you will pay both an upfront PMI premium and an annual premium, until your home equity reaches 20% LTV. [Your home equity will gradually rise both as you repay the loan and if the value of the home appreciates].

Of course, the reality is slightly more nuanced. The actual importance of the down payment will depend on numerous other factors, including your credit score. In the end, you should first seek to understand the position of your lender before determining the size of the down-payment.