Ask anyone thinking about buying a home for the first time what their biggest obstacle is and chances are good you’ll hear, “saving for the downpayment.”
In fact, the 2019 Profile of Home Buyers and Sellers from the National Association of REALTORS® (NAR) reported that 26% of first-time buyers said saving for the downpayment was the most difficult part of the buying process, citing student loans as the biggest obstacle, followed by credit card debt and car loans.
There’s no doubt that saving for a downpayment takes time, planning and effort by potential buyers. However, it doesn’t need to be a deterrent from buying a house for the first time! Our guide to downpayments will break down everything you need to know about:
- How much of a downpayment you’ll need
- How your downpayment affects your loan terms
- If your downpayment can be a gift
- Downpayment requirements for each loan type
- Downpayment assistance for first-time buyers in Iowa
Click any of the links above to jump to a certain section. Let’s dive in!
Everything First-Time Homebuyers Should Know About Downpayments
If you’re financing your home purchase, you will make a cash downpayment to your loan provider on the sale price of the house and then you’ll take out a home loan to cover the rest. Downpayments can be anywhere from 0-20%, or more, depending on your loan type and your financial situation. Typically, you should have most or all of your downpayment already saved before you start working with a lender to get home loan pre-approval.
You do not need to put 20% down- but it can affect your loan terms.
There are a lot of misconceptions among first-time buyers about downpayments and one of the biggest ones is how much you need to put down. Many first-time buyers have been told they need at least 20% of the home’s purchase price saved. This is not true anymore!
Most lenders will tell you that nowadays the minimum downpayment you’d need is 3% of the house’s purchase price. That’s a big difference! Some loans, like a VA or USDA loan, can waive the downpayment completely. According to NAR, in 2020, the average downpayment made by first-time buyers was 10%, which was up from 6% in 2019.
In 2020, the median existing-home sales price nationally was $311,800 which puts a 3% downpayment at about $9,354. A 20% downpayment would amount to about $62,360. This sales price is based on national averages so prices in your area may vary. But the difference in savings between 3% and 20% downpayments is substantial- and might make all the difference in whether or not a first-time buyer is able to become a homeowner.
Why Aren’t First-Time Buyers Putting 20% Down on a Home?
Source: Copyright ©2020 “2020 NAR Home Buyer and Seller Generational Trends” NATIONAL ASSOCIATION OF REALTORS®. All rights reserved. Reprinted with permission. December 18,2020, https://www.nar.realtor/research-and-statistics/research-reports/home-buyer-and-seller-generational-trends
Younger buyers are putting less down due to the amount of debt they carry. This includes student loans, car loans, credit card debt, childcare expenses and healthcare costs. The 2020 NAR Home Buyer and Seller Generational Trends Report found that 32% of buyers aged 22-29 were delayed in saving for a downpayment by two years and 25% of buyers aged 30-39 were delayed by more than five years. And it’s not just millennial first-time buyers! About 44% of buyers aged 40-54 were delayed by debt for more than five years as well.
Saving up 20% for a downpayment is a great idea if you are able to make it happen. It would put you in a strong financial position with your lender and would help you set good terms for your mortgage. But realistically, most first-time buyers aren’t able to save that kind of cash because so many are struggling to save while paying down record-high levels of student loan debt.
Does this mean you should wait to save up 20% while continuing to rent or should you put down a smaller downpayment? It depends on your situation.
It doesn’t always make financial sense to continue to rent while you wait years to save a 20% downpayment. You can calculate how long it makes financial sense for you to rent with a rent vs. buy calculator. We like this one from Nerdwallet because you can include your location, home purchase price, downpayment percentage and how much you currently pay in rent. This will give you a good idea of when it becomes financially sensible to become a homeowner and how long you should save for a downpayment.
How does your downpayment affect your loan terms?
The size of your downpayment can affect your loan terms, but it isn’t the only determining factor. Lenders look at quite a few factors when it comes to determining your home loan terms: your credit score, debt-to-income ratio, savings, overall financial state and the amount of your downpayment, just to name a few. In combination with your downpayment, these factors can affect your interest rates, monthly payments and whether you will have private mortgage insurance.
Interest Rates
Sometimes a higher downpayment will translate into a lower interest rate because you appear to be a less risky borrower to a lender. Right now, interest rates are at historic lows and are projected to stay relatively low through 2021 as the Federal Reserve announced it will continue to buy mortgage-backed bonds. Most first-time buyers will likely be able to get low interest rates right now, assuming the rest of their finances are in order.
Monthly Payments
A large downpayment also takes more off the balance of your loan which would lower the monthly payments. Borrowing less also reduces the total amount of interest you’ll pay over the life of the loan. If you choose a fixed-rate home loan, your payments will be the same amount every month for the loan term. If you choose an adjustable-rate mortgage, your payments will fluctuate as your interest rate changes. Talk to your lender about how your downpayment amount can affect your monthly payments with both loan types.
Private Mortgage Insurance (PMI)
You’ve probably been warned that you’d be stuck with mortgage insurance if you don’t have the savings for a big downpayment. What is mortgage insurance and is it financially risky?
Conventional loans
Private mortgage insurance (PMI) is issued on conventional loans if your downpayment is less than 20%. It’s basically insurance for the lender in case you stop making your monthly payments. Most of the time PMI is added to your monthly mortgage payments but sometimes you pay a lump sum upfront.
“There are different types of mortgage insurance available. Some you pay monthly- which is normal. Some are single premium, split premium, or lender funded, which means you end up paying a higher interest rate,” explained Brian Swanson, the branch manager of Inlanta Mortgage in Des Moines. “If you are putting down less than 20% and have one loan, you are paying mortgage insurance somehow even if it doesn’t show that on your monthly statement.”
PMI can be anywhere from 0.5 to 1% of the total loan amount each year, depending on your lender and the terms of your loan.
The good news is the PMI payments won’t last for the entirety of your loan. Each lender varies but some will end your PMI once you reach a certain amount of equity in your home or they’ll set a predetermined length of time.
FHA loans
FHA loans always require PMI but it’s structured differently. Buyers with FHA loans will have PMI for the life of the loan if their downpayment is less than 10%. If they put down a downpayment that is more than 10%, the PMI only lasts for 11 years.
The mortgage insurance payments are put into an escrow account by the U.S. Treasury Department to be used in case the borrower defaults on the loan.
Spending extra money every month on mortgage insurance probably doesn’t seem ideal, but it’s not the end of the world!
“Even though it’s not great, it does give someone the opportunity to purchase and start to build equity long before they may have been able to if they waited to save a full 20% downpayment,” explained Swanson. “The amount of equity they gain in the property will offset the cost of the mortgage insurance premiums.”
VA and USDA loans don’t require PMI at all (although they do have funding fees). Talk to your lender about your options and work with them to calculate if it’s in your financial interest to start earning equity, even if it comes with PMI every month.
Downpayments can be gifted.
Another source for your downpayment, other than your savings, can be gifts from family members or friends. According to the 2020 “Downpayment Expectations & Hurdles to Homeownership” presentation from NAR, 32% of first-time buyers in 2019 received a gift or loan from relatives or friends for their downpayments. First-time buyers aren’t alone in receiving gifted funds- 8% of repeat buyers that year also used gifted money to fund their downpayments.
Gifted money for a downpayment has to be a true gift, not a loan. A loan, even an informal one from family members, increases your debt-to-income ratio which affects your eligibility for loan approval.
Be honest with your lender about gifted money and if you have plans to pay it back. Any money you intend to return to the lender is a loan, not a gift, and should be factored into the loan process. It could come back to bite you if your lender finds out it’s a loan and not a gift.
Your lender should review the guidelines for gifted money with you, which includes who can give you money, the rules for each loan type and how to declare gifted money.
Who is allowed to give you downpayment money?
Family members and friends with the means and motivation are allowed to transfer money to you to be used for a downpayment. But different lenders have different rules for who can give you money for a downpayment.
The government-sponsored agencies that back most conventional loans (Fannie Mae, Freddie Mac, etc.) allow gifted downpayments to come from family members, which includes relatives by blood, marriage, adoption, domestic partners and fiancés. However, gifts are not allowed on investment properties.
FHA loans, which are backed by the Federal Housing Administration, allow downpayment money to come from friends, labor unions and employers, in addition to family members.
USDA and VA loans have fewer restrictions. Anyone you have a relationship with can give you money for a downpayment, as long as they’re not an interested party (someone involved in the purchase or sale of the home).
Who can’t give you money for a downpayment?
The home seller, real estate agents, home builders and anyone who has a vested interest in the home selling. These restrictions apply to all loan types. Anyone who stands to benefit from the purchase or sale of the house cannot provide you money for a downpayment.
Are there rules for how much of the downpayment can be a gift?
Yes! Each loan type has different requirements when it comes to sources of downpayments. Your entire downpayment can be gifted with FHA loans, if your credit score is above 580. If your credit score is below 580, only 3.5% of your 10% downpayment can be gifted.
VA and USDA loans don’t typically require downpayments at all, but if you are paying one it can be entirely gifted money.
Your entire downpayment can be gifted with conventional loans if your downpayment is 20% or less.
How do you declare gifted funds?
All lenders will require you to declare that you are using gifted funds for your downpayment- you can’t just transfer money to your account!
To declare gifted funds for a downpayment, you will submit a gift letter to your lender. Each lender is a little different in how they want the letter structured, but it will generally include:
- The name and address of the person giving you money
- The amount of money they’re giving you
- What kind of relationship you have with the gift giver
- The address of the home you’re buying
- The source of the gift (investment funds, checking account, etc.)
- A statement that the money is a gift, not a loan
- Both your signature and the gift giver’s signature
You will also have to document and provide proof of receiving the funds. Your lender may ask for a bank statement showing the money in your account, a copy of a canceled check made out to you or paperwork showing a money transfer to you. If the person gifting you money is selling investments to fund the gift, you will also need a statement from their brokerage account. FHA loans require more extensive documentation of bank transfers, your lender should review those requirements with you.
As the recipient of gifted funds, you won’t be responsible for any tax implications. However, the person giving you money will have to pay gift taxes on it if the gift is over a certain amount. In 2020, the limit was $30,000 for parents filing jointly or $15,000 for someone filing individually (a single parent or removed relative like an aunt).
Gifted downpayments can be helpful for first-time buyers who are struggling to save for a home. Talk to your lender as early as possible about documenting gifted funds and what your loan provider will require of you.
Different loan packages have different downpayment requirements.
Each loan type has different requirements for downpayment amounts. When you first meet with a lender, ask questions about what kind of home loans you qualify for and how your downpayment will affect the terms.
Conventional Loans
These are the most common types of home loans. In fact, 62% of all buyers in 2020 used conventional loans to finance their home purchases, according to NAR. These typically require a minimum of a 3% downpayment but this can be higher depending on your lender. Whether you obtain conventional financing through a bank, credit union, independent contractor or national company, they will all require some kind of downpayment.
Conventional loans are backed by agencies like Freddie Mac and Fannie Mae which buy these loans from lenders. Depending on who you take out a loan with, you might be required to meet additional qualifications called overlays.
An overlay is a qualification requirement applied to you by a lender. Basically, if a lender thinks you might be a risky loan, they may require you to meet extra guidelines in order to be considered eligible for a loan. The extra qualifications make it more certain they’ll be able to sell your loan to an organization like Freddie Mac.
One of those considerations is the size of your downpayment. If your credit score is on the lower end or your debt-to-income ratio is high, a lender might require you to make a higher downpayment to outweigh the risks.
VA Loans
VA loans are offered to active duty service members and veterans through private lenders and guaranteed by the U.S. Department of Veteran Affairs. A VA loan offers low interest rates without adding on mortgage insurance. Funding fees can be applied to the loan and those go directly to the VA to pay for the loan.
VA loans do not require a downpayment, although you can certainly put one down if you want and are able to do so. This is a big benefit for first-time buyers who qualify for VA loans, although it does mean you start off with the entire home price as your loan balance.
It is still a good idea (and your lender will probably require it) to have plenty of cash saved up to cover closing costs, the cost of the home inspection and anything else that might come up.
FHA Loans
An FHA loan is backed by the Federal Housing Administration and must be issued by an FHA-approved lender. Nowadays, FHA loans are most commonly issued to first-time homebuyers because of the reduced qualification requirements. They’re designed to make housing accessible for anyone who might not otherwise qualify for a conventional loan.
FHA loans are structured for anyone with high debt-to-income ratios and low credit scores. These loans generally require a 3.5% downpayment with a minimum credit score of 580, but you may be able to qualify with a lower score if you are able to put down a 10% downpayment.
While other home loans have restrictions on the sources of your downpayment funds, FHA loans allow more flexibility. Many borrowers who are first-time or low-income and can only qualify for an FHA loan may need financial assistance to make a downpayment. Your lender can point you in the right direction for downpayment assistance if need be.
USDA Loans
A USDA loan is backed by the U.S. Department of Agriculture and is issued to homebuyers in designated rural areas whose household incomes are below the income limit set by the USDA. These loans are structured to assist low-income buyers. USDA loans do not require a downpayment but will have funding fees.
Remember, you still should have plenty of cash saved up to cover closing costs, the cost of the home inspection and anything else that might come up.
Downpayment assistance for first-time homebuyers in Iowa.
Did you know there are dozens of downpayment assistance programs, grants and loans specifically for first-time homebuyers? Even if you don’t think you qualify for assistance, you should review some of these programs. There are many resources available for first-time buyers- take advantage of them!
We compiled a list of some of the best first-time homebuyer programs, loans and grants from a combination of federal, state, county and city providers for buyers in Iowa. It’s by no means a complete list of every program offered by every single agency in the state, but it should help you get started.
Many of these programs can be used in combination with financing from a lender. However, not every lender in the state accepts all of these programs’ assistance. If you’re already working with a lender, talk to them about which of these programs is right for you and which ones they can accept. If you’re not already working with a lender, many of these program providers have preferred lenders they work with and can put you in touch with.
Buying a home for the first time is a huge milestone. Don’t let saving for the downpayment deter you from becoming a homeowner. Talk to a lender as early as you can to review your financial situation, loan eligibility and discuss the loan options that work for you so you can save for a downpayment that will help you qualify. Don’t be afraid to take advantage of downpayment assistance programs that can help make the home buying process easier.
Looking for more information on buying a home for the first time? Our first-time homebuyer series can help guide you every step of the way.
Real talk: buying a house can be intimidating. So we created the first-time homebuyer series to take the mystery and anxiety out of the house-hunting process. Dive into our complete guide which covers every step of the process so you’ll have all of the information you need for a successful purchase right at your fingertips.