Accumulating the Down Payment to Buy a Home

You've finally found your dream home and you're already imagining how to decorate it, how your parties will be fabulous, and how your family will love it. Back to reality: After going through all of the loan documentation requirements and closing costs, you soon discover that you can't afford to buy the house because you haven't saved enough. Don't let this happen to you.

The 20 percent solution
Ideally, you should purchase a home and have enough accumulated for a down payment so that your down payment represents 20 percent of the purchase price of the property. Why 20 percent and not 10 or 15 or 25 or 30 percent? For the same reason that Goldilocks, at the residence of the three bears, liked the moderately warm bowl of porridge and disliked the bowls of porridge that were very hot and stone cold.

Twenty percent down is the magic number because it's a big enough cushion to protect lenders from default. Suppose, for example, a buyer puts only 10 percent down, then property values drop 5 percent, and the buyer defaults on the loan. When the lender forecloses — after paying a real estate commission, transfer tax, and other expenses of sale — the lender will be in the hole. Lenders learned the hard way that buyers are far less likely to default on and walk away from a home on which they pay 20 percent down. Lenders don't like losing money. They found they are far less likely to lose money on mortgages where the borrower has put up at least a down payment of 20 percent of the value of the property.


If, like most people, you plan to borrow money from a bank or other mortgage lender, be aware that almost all require you to obtain (and pay for) private mortgage insurance (PMI) if your down payment is less than 20 percent of the purchase price of the property. Think of the mortgage lender as Goldilocks — the person who needs to be satisfied. Although PMI typically adds several hundred dollars annually to the cost of your loan, it protects the lender financially if you default. Should you buy an expensive home — into the hundreds-of-thousands-of-dollars price range — PMI can add $1,000 or more, annually, to your mortgage bill. (You can also expect worse loan terms such as higher up-front fees and/or a higher ongoing interest rate on a mortgage when you make a down payment of less than 20 percent.)

PMI is not a permanent cost. Your need for PMI vanishes when you can prove that you have at least 20 percent equity (home value minus loan balance outstanding) in the property. The 20 percent can come from loan paydown, appreciation, improvements that enhance the value of the property, or any combination thereof. Note also that, to remove PMI, most mortgage lenders require that an appraisal be done — at your expense.


Ways to buy with less money down
"But I can't save a 20 percent down payment plus closing costs. What do you think I am, a professional athlete?!"

Digging out from consumer debt and saving 20 percent of a property's purchase price as a down payment plus closing costs can seem like a financial mountain —especially if you're just starting to save or are still paying off student loans or worse.

Don't panic and don't give up. Here's a grab bag filled with time-tested ways to overcome this seemingly gargantuan obstacle:

Boost your savings rate. Say that you want to accumulate $30,000 for your home purchase, and you're saving just $100 per month. At this rate, it will take you nearly two decades to reach your savings goal! However, if you can boost your savings rate by $300 per month, you should reach your goal in about five years.
Being efficient with your spending is always a good financial habit, but saving faster is a necessity for nearly all prospective homebuyers. Without benevolent, loaded relatives or other sources for a financial windfall, you're going to need to accumulate money the old-fashioned way that millions of other homebuyers have done in the past: by gradually saving it.
Trim excess spending, stick to a budget, and begin saving as early as you can.

Set your sights lower. Twenty percent of a big number is a big number, so it stands to reason that 20 percent of a smaller number is a smaller number. If the down payment and closing costs needed to purchase a $150,000 home are stretching you, scale back to a $120,000 or $100,000 home, which should slash your required cash for the home purchase by about 20 to 33 percent.
Check out low-down payment loan programs. Some lenders offer low-down-payment mortgage programs where you can put down as little as 3 to 10 percent of the purchase price. To qualify for such programs, you generally must have excellent credit and purchase private mortgage insurance (PMI). In addition to the extra expense of PMI, expect to get worse loan terms — higher interest rates and more up-front fees — with such low-money-down loans. Check with local lenders and real estate agents in your area.
Unless you're champing at the bit to purchase a home, take more time and try to accumulate a larger down payment. However, if you're the type of person who has trouble saving and may never save a 20 percent down payment, buying with less money down may be your best option. Be sure to shop around for the best loan terms.
Look into seller financing. Some sellers don't need all the cash from the sale of their property when the transaction closes escrow. These sellers may be willing to offer you a second mortgage to help you buy their property. In fact, they often advertise that they're willing to assist with financing. Seller financing is usually due and payable in five to ten years. This gives you time to build up equity or save enough to refinance into a new, larger 80-percent conventional mortgage before the seller's loan comes due.
Be cautious about seller financing. Some sellers who offer property with built-in financing are trying to dump a house that has major defects. It's also possible that the house may be priced far above its fair market value. Before accepting seller financing, make sure that the property does not have fatal flaws (have a thorough inspection conducted) and is priced competitively. Also, be sure that the seller financing interest rate is as low or lower than you can obtain through a traditional mortgage lender.