The Ins and Outs of Down Payments

In today’s lending climate, down payments are definitely in fashion. A recent Bankrate.com article gives you the low-down on your down payment.

In recent years, no-down payment loans were extremely popular, especially with first-time buyers. With the recent lending crisis, lenders have tightened their standards and almost always expect buyers to come to the table with some money upfront.

Quite simply, the advantage of having a down payment today is that you will be able to qualify for a loan, since there are very few “zero-down” loan programs still in existence. Down payments also have other benefits, including reducing your monthly payments, explains Greg Gwizdz, national sales manager at Wells Fargo Home Mortgage in Des Moines, Iowa.

Basically, your down payment becomes instant equity when you close, and that equity can be borrowed against with a home equity loan or line of credit. You should be aware, however, that guidelines to qualify for these types of loans have become stricter, cautions Gwizdz. He says that many first-time homebuyers are “surprised by the true cost of owning and maintaining their home,” and recommends that they keep some reserves instead of throwing all of their money into a down payment. Some loan programs even require cash reserves for this reason.

Additional benefits of a down payment include:

• Borrowing less money to buy the same-priced home
• Increased choice when shopping among lenders, loan originators and loan products
• Getting a better interest rate
• Paying less for mortgage insurance
• Avoiding mortgage insurance altogether, if your down payment is at least 20 percent of the purchase price

Getting a Down Payment

Many homebuyers struggle to come up with a down payment, as it can be a significant chunk of money. Many homebuyers struggle to come up with a down payment, as it can be a significant chunk of money. Consider that if you put 20% down on a $200,000 house, that is $40,000! Even a 10% down payment is $20,000. Here are a dozen ways to get a down payment if you are ready to buy a home:

1. Set up an automatic saving plan.
2. Sell a car, a boat, collectibles or other assets.
3. Get a gift from a relative or friend, or ask for money to put toward a down payment instead of holiday or birthday gifts.
4. Liquidate stocks, savings bonds, mutual funds or other investments.
5. Allocate your income tax refund to go toward your down payment.
6. Take a loan from your 401(k) retirement plan, but pay yourself back with interest.
7. Withdraw funds from your 401(k), but remember that they are subject to taxes and penalties.
8. Collect on a loan you made to someone else.
9. Get a bonus or raise from your employer.
10. Explore homebuyer programs for public servants, if you qualify.
11. Apply for a state or local government homebuyer down payment assistance program.
12. Use a private down payment assistance program.

You can also work on small ways to save money, such as cutting out your morning gourmet coffee stop, bringing your lunch and eating out less. Just make sure you contribute the money to your down payment fund; create a separate account if you have to.

Gwizdz cautions that a down payment needs to be “sourced and seasoned,” meaning that your lender needs to know how you obtained the funds and that you have had control of them for at least several months. Gifts and seller’s concessions are acceptable, but only up to a percentage allowed by the loan program. Remember that borrowed money cannot be used as a down payment because it is considered a debt that has to be repaid.

Government-backed Programs

If you are struggling to save for a down payment, there are two government-run programs that are designed to help. The Federal Housing Administration (FHA) offers mortgage insurance that allows qualified buyers to purchase a home with a 3% down payment, and that down payment may be entirely a gift. Also, the U.S. Department of Veterans Affairs has a home-loan guarantee program that will help military veterans buy a home with no down payment.

You may also be able to find a down payment program that offer grants and low-interest deferred-payment loans and are run by state or local housing authorities. Be warned that the restrictions can be “pretty severe,” says Ed Craine, CEO of Smith-Craine Finance, a mortgage company in San Francisco. For instance, some programs may have income restrictions or require buyers to live in a disadvantaged neighborhood. “The biggest problem tends to be that if you make enough money to qualify for a loan, you probably make too much money to get the down payment assistance,” Craine explains.

There are also down payment assistance programs offered by private organizations, such as Nehemiah Corp. and AmeriDream, two of the largest. These organizations convert money contributed by the seller into the buyer’s down payment and assist with seller concessions. “They are using the seller’s equity to fund a grant which allows the buyer to buy with no money down,” explains Peter Thompson, a senior loan officer with Professional Mortgage Partners in Downers Grove, Illinois.

These types of programs “serve a need for people who struggle to save a down payment, if the seller is motivated to contribute,” says Gwizdz. Like a lot of loan programs, these types of programs are not without controversy. Gwizdz points out that the down payment is only worthwhile if the homebuyer can afford the monthly payments. Also, someone who is unable or unwilling to save for a down payment may also not be able or willing to make monthly payments.

The FHA has tried, unsuccessfully so far, to ban using private down payment assistance programs in conjunction with FHA loans, since FHA-insured loans that used these programs had a higher rate of default and foreclosure than loans that didn’t use private assistance, according to an FHA study. “FHA loans made to borrowers relying on ‘seller-funded down payment assistance’ go to foreclosure at three times the rate of loans made to borrowers who make their own down payments,” stated FHA Commissioner Brian Montgomery in a May 2008 speech. Alternatively, the private down payment assistance industry believes strongly that the government shouldn’t restrict access to home ownership.

Down Payment vs. Closing Costs

Which would win in a battle, money allocated to a down payment or set aside for closing costs, for a buyer with limited funds? The simple answer is that the down payment should come first, up to at least 5% of the purchase price (or 3% for an FHA-insured loan). Peter Thompson explains, “It doesn’t matter if they have the money for closing costs if we can’t show [the lender] that they have the money for the down payment.”

Got your down payment but are stuck for the closing costs? Here are a few options:

• Request that the seller pay closing costs.
• Pay a higher interest rate in exchange for your lender covering closing costs.
• Wait to buy a home until you have saved enough for both.

If you are going to ask the seller to pay for closing costs, you need to discuss that concession before you sign a purchase contract, since payment of costs is negotiable and can affect the seller’s net proceeds from the transaction, Thompson says.

You can also reduce or eliminate closing costs by paying a higher interest rate on your mortgage, Craine says. Discuss this option with your lender to find out exact details, but the usual rule of thumb is that an additional 1/8 of a percent higher in your interest rate will net a credit against closing costs of ½ of a percent of the loan amount. For example, an additional ¾ of a percent in interest may eliminate closing costs of 3%.

There is a catch: as your credit increases, you have to take a bigger interest rate jump to achieve the same amount of savings. “Instead of your total costs being 3% at one end of the spectrum and zero at the other end with a ¾-percent higher interest rate, you could compromise on whatever combination of closing costs and interest rate you want,” Craine adds. Ideally, a homebuyer should save enough money to cover both the down payment and the closing costs and still be able to cover his or her monthly mortgage payments. You may consider biding your time until your finances are ready to go!