The purpose of this article is to dispel the common misconception that you can only buy a home if you have 20% of the purchase price saved for a down payment and to explain how you can buy a home with less money down.
So where does the misconception of 20% down come from? Lenders offer the best loan terms to those borrowers that put at least 20% down because the loan is perceived to be less risky than a loan for someone who has less “skin in the game.”
However, because not everyone can come up with 20% down, lenders offer programs that allow borrowers to put less money down, but they come with extra conditions to protect the lender against the risk that a borrower will default on his or her loan.
What is a down payment?
A down payment is the personal cash contribution that you make in a purchase transaction. Programs exist for down payments as low as 3% for one-unit properties that you intend to live in as your primary residence and if you are active in the US military or a veteran, programs exist that allow you to buy without putting any money down.
If you are purchasing a home that you will not occupy as your primary residence (i.e. second homes or investment properties), the options to buy the property with less than 20% down are limited.
How can I buy a home with less than 20% down?
There are two ways that you can buy a home when putting less than 20% down: paying for mortgage insurance or securing a second loan.
Mortgage insurance reimburses the lender if a borrower defaults on their loan. The borrower is responsible for paying the monthly premiums for this policy.
Lenders can secure mortgage insurance policies from the Federal Housing Administration (FHA), state-sponsored government agencies or non-government organizations, which is referred to as private mortgage insurance (PMI). In all cases, the lender will secure the policy as part of the transaction, but they are required to provide you with the options available to them because you are responsible for making the payments. The details of the policy will be shown in your disclosures and closing documents.
Mortgage insurance can be paid upfront or in monthly installments. There are also options whereby the lender will pay the PMI premium(s) on behalf of the borrower, however this will result in a higher interest rate on the loan. For the monthly installment programs, you will make the payments as part of your monthly mortgage payments.
The lender is required to cancel your private mortgage insurance payments when the loan-to-value ratio drops to 78%. In some cases, your lender will accept a request to drop the policy when the loan-to-value ratio reaches 80%, but they are not required to do so. FHA-insured loans require payment of mortgage insurance premiums for the life of the loan. FHA mortgage insurance premiums cannot be canceled unless you refinance your loan into a non-FHA loan. The cancellation provision for mortgage insurance policies offered through state-sponsored programs vary by state.
Certain lenders will allow you to put less than 20% down and avoid mortgage insurance by combining your first mortgage with a second mortgage. This second mortgage is sometimes referred to as a “subordinate” loan because in the event of a default, the first mortgage owner is entitled to repayment before the second mortgage is repaid.
In some instances, a second loan will result in better terms than getting a single loan with PMI. A common structure for subordinate financing is the 80–10–10, where the “80” refers to the percentage of the purchase price provided by the first mortgage, the first “10” refers to the percentage of the purchase price provided by the second mortgage and the final “10” refers to your down payment.
The 2nd mortgage or subordinate financing typically consists of a variable rate home equity line of credit (HELOC) or a fixed rate loan. The rate on the second mortgage is almost always higher than the rate on the first mortgage to compensate the subordinate lender for the additional risk associated with a smaller down payment, but it is not uncommon for the combined payments to be less than a single loan with mortgage insurance.