Interest rates are low and home prices have plummeted from their 2008 highs, making it an ideal market for homebuyers. But before even starting the hunt, every buyer needs to determine exactly what they can afford and how much they will need for a down payment.
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While a down payment is sure to be in the thousands, 90% of new mortgages are government-backed conventional (Fannie or Freddie) and FHA loans, according to Bob Walters, chief economist at Quicken Loans, that only require 3.5%-9% upfront, compared to the standard 20%. Veteran Home loans or VA loans sometimes finance the entire home purchase and don’t require a down payment.”
“Most clients that apply for an FHA loan put down the lowest available down payment of 3.5% to 5%. This is the major advantage of an FHA loan,” say Noah Brown, a mortgage loan originator at American Mortgage Group. Keep in mind that if you don’t put down 20%, you’ll likely have to pay for private mortgage insurance on top of your mortgage payment until you have enough equity in the home.
Calculating How Much Home You Can Afford
When you get pre-approved for a loan, the lender will tell you the maximum you can borrow based on your debt to income. Most banks set the debt to income ratio at 45% to 50%, which means you’re debt can’t exceed 50% of your income. Once your debt to income ratio is determined, the bank will tell you how much of a home you can afford.
Experts warn buyers that just because they are approved to borrow a certain amount, it could be more practical to borrow less to have more flexibility with other lifestyle spending. If you like to eat out every night, enjoy weekly shopping trips or have an expensive lifestyle buying the maximum house you can afford could leave you strapped for cash. “Some clients may not feel comfortable with a debt-to-income ratio of 50% and thus look for a lesser value home, with the knowledge of what they can afford / qualify for,” says Brown.
Once you know what you can afford, next you need to figure out the down payment amount and how to come up with it. According to Brown, you should never use the majority of your assets to for your down payment—putting 20% down instead of 25% will leave some emergency funds in the bank.
Collecting funds for the down payment also varies by financial situation. According to Walters of Quicken Loans, the majority of people use money from their savings account or from the sale of a previous home as the down payment.
If you don’t have adequate savings for the payment, you can tap your 401(k) or IRA, although experts warn you could be hit with significant penalties for withdrawing early. Most lenders allow a portion of the down payment to come from a gift as long as it’s a gift with no strings attached. “Lenders want to make sure it’s a gift and not a loan,” says Walters. “They don’t want an over leveraged client.”
You can not charge your down payment or otherwise borrow money through an unsecured loan because they will increase your debt-to-income ratio.
There are non-profit companies that offer eligible buyers assistance in buying a home. For instance AmeriDream, a non-profit focused on helping people find affordable housing, helps people with low and moderate incomes buy homes by offering down-payment assistance. Buyers who are approved for an FHA loan, but don't have the money for the down payment can apply for the AmeriDream down payment assistance.
The Nehemiah Program, which is a down payment assistance program that offers help to buyers who qualify for an FHA loan. With this program there are no limits on income or assets. For a list of down payment assistance programs click here.