Homeownership is often seen as a gateway to financial security: Once you buy a home, you can begin to build equity, adding to your net worth and future financial well-being. Plus, on a monthly basis, renting can be just as expensive as owning a home—or even more so—without building any equity at all. So while a home is the largest purchase you’ll likely ever make, it’s also one of the most important.
Despite the attractiveness of homeownership, however, many people find the first step—saving enough for a down payment—a daunting prospect. Here is a primer on what you need to know about down payments.
What Is a Down Payment and Why Do You Need One?
A down payment is a cash payment on your home, calculated as a percentage of the purchase price. It is seen by a bank or mortgage lender as a financial commitment that demonstrates both your interest and capability in paying for the home.
For a prospective homebuyer, the down payment is sometimes seen as a barrier to buying a home—saving up a huge chunk of cash can be intimidating. But the down payment should be seen as a tool you can use to your advantage as a discerning consumer.
How Much Down Payment Do You Need?
Although a typical down payment amount is 20% of the home’s value, people often put much less down. In fact, first-time buyers can often buy a home with a relatively small down payment. The average down payment for first-time homebuyers in 2021 was just 7%, according to the National Association of Realtors. But of course, your financial situation and your personal preferences will influence the size of your down payment. The key is to know you have options and to make an informed choice before signing on the dotted line.
It’s ultimately a trade-off: If you pay a larger down payment, you’ll lower your monthly mortgage payments; if you save on your down payment now, you’ll have larger monthly payments over time. A mortgage representative can walk you through the various options using the actual details of a prospective home to make this clearer, but it functions effectively the same.
To illustrate, let’s assume you want to buy a home worth $300,000. A 5% down payment on this would be $15,000, leaving $285,000 owed on the home to be paid via mortgage. Meanwhile, a 10% down payment on the same $300,000 would equal $30,000 down, leaving $270,000 owed on the home.
The actual mortgage payments would depend on the length of the mortgage and the interest rate you pay. Let’s assume a 30-year mortgage and 6.9% interest rate: A $285,000 mortgage would require approximately $1,877 monthly payments; a $270,000 mortgage would trim that to $1,778.
You can plug your own numbers into a mortgage calculator to look at your options and consider what you feel most comfortable with—and what you can conceivably afford both as a down payment and monthly mortgage payment.
Private Mortgage Insurance
If your down payment is less than 20% of the home’s value, your loan-to-value (LTV) ratio will be greater than 80%. In that case, you’ll need to make additional payments called private mortgage insurance (PMI) until you reach the threshold where your LTV ratio drops below that 80% mark.
Although no one likes paying PMI, it’s a useful way for people to purchase a home with less than 20% down, making homeownership more accessible to more people. Over the course of one’s financial life, paying PMI for a few years can be worthwhile as it can open the door to accumulating significant equity as you pay off your principal.
How to Save for a Down Payment
Saving for a down payment could take a few years if you are striving to pay the typical 20% down. On the $300,000 hypothetical home from before, that would total a down payment of $60,000, which may seem daunting.
Alternatively, as an example, consider using the 7% average first-time homebuyer’s down payment—that would be just $21,000. Depending on your situation, you could save or borrow money over 12 or 18 months if your time horizon for homebuying is closing in.
First things first, you’ll need to figure out where the money will come from. Analyze your budget and limit your discretionary expenses for a year or two to rechannel that money, and ask yourself which expenses you could cut back on. Perhaps skip a vacation and channel the money not spent into the down payment fund. Also, now is the time to consider ways to increase your income. Could you take on a side gig or work overtime?
Ensure you pay off as much high-interest debt as possible before applying for a mortgage and saving for the down payment, so your money will go further.
Ask yourself if you can take existing savings and funnel them into this project. For example, if your emergency fund is nearing $20,000, while you might not want to deplete it, perhaps you could use half of it and plan to gradually replenish that source of savings over time.
Borrowing from your retirement fund is another option. Although it is generally frowned upon, if dipping into your retirement savings for this goal would improve your long-term financial security, that could be worthwhile. Make sure you consult with a financial professional before doing so to ensure it’s the right move for you.
Finally, borrowing from family or friends may be something to take a look at. You can figure out a repayment plan with interest that’s lower than a typical loan, saving you money in the long run.
When saving for a house, it’s a good idea to use an account that is suitable for your time frame but also offers a competitive interest rate. If your timeline is shorter than a year, a high yield savings account or money market account could be an attractive option. By opening a separate account specifically to save for your down payment, you can make your money work for you during this time. high yield savings account. money market account
How to Make a Down Payment More Affordable
If you are looking for ways to reduce your down payment and make it feasible to own a home sooner, here are a few possibilities:
An FHA loan: These mortgages are insured by the Federal Housing Administration and are often used by first-time homebuyers. If you qualify, you could get a loan with as little as 3.5% down.
A VA loan: If you are a veteran, an active service member or a surviving spouse, you might be eligible for one of these government-backed loans that could involve as little as 0% down. However, always be aware of the risk of carrying a higher mortgage. Your monthly payments will be larger, and the total amount of your interest payments over the course of the mortgage will be greater. With higher mortgage rates, that should be a major consideration before opting for this choice.
A fixed-rate conventional loan: You might obtain this kind of loan with a minimum of 3% down.
State and local assistance: Search online for any state or local programs available for first-time homebuyers in your area.
Don’t Take On Too Much Debt
Always be careful not to overextend yourself financially when buying a home. Paying a smaller monthly amount on your home (including mortgage, insurance and property tax) could make it easier and less stressful for you to address the many other financial obligations that will crop up in the coming years, such as childcare, college savings, vacations or retirement.
Allan Kunigis is a financial freelance writer based in Shelburne, VT. He has written about personal finance for more than two decades.
Illustration by Darya Semenova
LEARN MORE: Save or Pay Down Your Mortgage?