Borrowing Money for a Down Payment on a Home
When you’re in a bind, it’s not unusual to borrow money to get back on on your feet. But how about borrowing money for a down payment on one of the biggest purchases you’ll make in your life?
Maybe you’ve spotted the home of your dreams, interest rates are low, you’re making good money and you’re ready to make an offer on the house. While you’re confident that you can afford the monthly mortgage payment, you don’t have enough money saved for a down payment. In this scenario, it may make sense to borrow the funds, especially if you want to lock in a low mortgage rate.
“When you look at the value of real estate in terms of deductions and the potential to be able to keep money that you’re spending rather than having it go into rent for somebody else, it’s always good to make the purchase,” said Greg Crossfield, realtor with Long & Foster in Washington, D.C.
Avoiding private mortgage insurance is another reason you might want to borrow for a down payment. For conventional mortgages, if you don’t put down 20%, you’ll need to pay monthly insurance premiums until you reach 20% equity in your home. Twenty percent is not a small sum of money. It amounts to $40,000 on a $200,000 home.
Even if you’re eligible for loan programs that allow for as little as 3% down — that’s $6,000 on a $200,000 home — you may still be challenged to come up with the funds. The good news is that if you don’t have any cash available for the down payment, there are several options to consider.
How to borrow money for a down payment
Borrowing money for a down payment on a home can be tricky, but armed with the right knowledge, you can do it. Here are some options.
Borrow against equity you have in an existing property
If you already own property and you’ve built up a good amount of equity in it, you may be able to borrow from the equity to fund the down payment. This can be done through a home equity loan (HEL). Although it’s more common to use home equity loans for purchases such as home renovations, these loans can also be used for buying another home.
Once you find a lender, they’ll order an appraisal to determine your existing property’s market value. Your equity is the home’s value minus your mortgage balance. That determines how much you can borrow.
When you get the loan, you’ll receive a single lump sum payment to use as you wish. You repay it in monthly installments.
Because your home serves as the collateral, the interest rate is typically lower than with other types of loans. Another benefit of a HEL is that the interest you pay is still tax deductible as long as you use the loan to buy, build or make major improvements on a home, according to the new tax reform legislation that went into effect in 2018.
The downside is that, because your home is collateral, if you don’t repay the loan in a timely manner, your house could be at risk of foreclosure.
Get help from family or friends
This is where mom and dad or a close friend can come into play. One of them can lend you money to help with the down payment. The problem with borrowing money is that it will impact your debt-to-income ratio, which could affect your ability to qualify for the mortgage.
A gift, however, is a different matter. The amount of the gift won’t interfere with your debit-to-income ratio and ability to qualify.
The Home Buying Institute recommends talking to a lender first to discuss getting down payment help from family members or friends. While both conventional and FHA loans allow for gifted down payment funds, they differ on how long the money needs to have been in the bank and what types of sources are allowable.
Lenders will want to see copies of your bank statements that show when the deposit was made. The HBI says that the sooner you get the money deposited into your account, the better.
More importantly, whoever is giving you the money must write a letter saying they don’t expect to be repaid.
Keep in mind, though, that mixing money and family or friends can be risky, and it often causes relationships to go sour. Be sure both you and the gift giver are prepared to handle the arrangement.
Borrow against your retirement funds
While it’s really not advised to raid your retirement savings to make a large purchase, you can do it if you’re in a pinch. Here are your choices:
401(k) or IRA distribution
If you’re under 59½ years old, you normally would have to pay a 10% tax penalty to take a distribution from a traditional IRA or 401(k) because it’s considered an early withdrawal. But the Consumer Financial Protection Bureau says, “If the money is used to buy, build or rebuild a first home, the penalty may be waived.”
There are a couple of rules to keep in mind, according to accounting firm Drucker and Scacceti. You can only withdraw up to $10,000 during your lifetime for this purpose. And you must be a first-time homebuyer. According to IRS rules, that means neither you nor your spouse can have owned a home in the two years prior to the home purchase.
Drucker and Scaccetti also note that the funds must be used on the house by the 120th day after you get the distribution. And keep in mind that you’ll still have to pay taxes on the distribution.
Roth IRA distribution
You can withdraw from a Roth IRA whenever you want without penalty. And because you used after-tax money to make your contributions, the distribution won’t be taxed when you withdraw, though the investment gains will be.
Another option is to take out a 401(k) loan. You can borrow up to half of your balance, or $50,000, whichever is less, per IRS rules. You’ll have to pay the loan back, which you can usually do by having money taken directly from your paycheck.
Note that if you default, the loan is considered a distribution and you’ll be subject to the 10% tax penalty. The money will also be taxed as regular income.
Also, be mindful that many 401(k) plans are structured so that you have to repay the loan once you leave the company. Be sure and check the rules.
A bigger concern is that one of the main benefits of saving for retirement in a 401(k) is the tax-free growth of investment earnings. If you hollow out the principal to fund your down payment, you’ll have less money in the retirement account to grow tax-free and your savings will not grow as quickly.
Take out a personal loan
A personal loan is rarely used or even allowed for funding a down payment on a home. This is because by taking out a personal loan, you are increasing your debt-to-income ratio, which will lessen the amount you’re qualified to borrow.
The interest rate is also much higher on a personal loan than some of the other options listed here. That’s because it’s unsecured debt, unlike a home equity loan in which the lender has your house as collateral if you default. Despite the potential risk, it can be an option in select circumstances.
Crossfield said there are also startup companies that will lend you the down payment. This is a relatively new trend, but according to MarketWatch, one company gives the borrower as much as half of the down payment amount or 10% of the home’s cost. When the owner sells, the firm takes a share of the profit or loss, which is usually 35%.
Get a loan from a community bank or credit union
A loan from a community bank or credit union may offer better financing terms than loans from a big commercial bank. That’s because these types of lenders are focused on the needs of the local communities they serve. Credit unions are also nonprofit organizations, so they may have more leeway to offer better terms.
However, just like other personal loans, this type of loan can increase your debt-to-income ratio and impact your borrowing power. It’s also important to find out the origination fees and whether there’s a penalty for paying the balance of the loan down early.
Grants and assistance programs provide an alternative to borrowing
If borrowing money seems daunting or you’d rather go another route, you can look into grants and down payment assistance programs as an alternative.
Down payment assistance programs
The U.S. Department of Housing and Urban Development is a good place to start to look for state-specific programs that offer help with mortgage down payments. Check here for exact details and qualification requirements.
You could be eligible for a state, county or city program that provides a grant or low-interest loan to pay for your down payment. In addition, check out the National Homebuyers Fund, a nationwide organization that provides down payment assistance.
In addition to down payment assistance, think about applying for a government-backed loan that requires a lower down payment. You could put down as little as 3.5% with an FHA loan, depending on your credit score.
Also, Crossfield explained that there are programs, especially for military members, that don’t require a down payment. VA loans for veterans and current military personnel are backed by the U.S. Department of Veterans Affairs and allow lenders to make loans without requiring the borrower to pay a chunk of money up front. However, be mindful of some of the fees associated with VA loans.
USDA loans, which target homebuyers in certain rural areas, also allow for no down payment from qualified borrowers. They’re sponsored by the United States Department of Agriculture.
Some conventional loan programs through Fannie Mae and Freddie Mac have 3%-down programs, as well. This allows you to at least put something toward the home’s equity and lessen the monthly payment. Both require borrowers to take a financial education class. And because the down payment is below 20%, you’ll need to pay for mortgage insurance.
With zero– or low–down payment programs, another pitfall to be aware of is that you’ll have less equity in your home than if you’d put down more money. If you try to sell your house before paying down a good chunk of the balance and before the home’s value has time to rise, you could get stuck being “upside down” on the home. This means that you could wind up owing more than the home is worth when you try to sell it. If you wait at least five years before selling, in most cases, you will have paid the balance down enough that this shouldn’t be a problem.
Armed with the right knowledge, borrowing money for a home down payment can be done sensibly. Make sure whichever route you decide on doesn’t impact your debt-to-income ratio so much that you’re defeating the purpose getting the down payment loan.
For a conventional loan, you’ll want to compare the interest on the down payment loan to the cost of paying for mortgage insurance if you put down less than 20%. You may be better off going the latter route.
Although you’ll have less equity to start out with by taking advantage of a zero– or low–down payment program, if you plan to be in the house for at least five years, you’ll have time to build up equity.