With housing prices and mortgage rates still near historic lows, now could be a great time to become a homeowner. I recently talked to a caller on our Financial Helpline who had a great credit score and could afford the mortgage payment for the home value she wanted since it would be about the same as her current rent. (In many parts of the country, it's actually cheaper to buy than to rent right now.)
There was one problem though. The traditional down payment is 20% of the home value but she only had enough to put down about 10% and was worried about missing years of building equity if she tried to save up the rest over time. If you're in a similar situation, here are some thing to consider:
You Need More Than the Down Payment
Keep in mind that you'll also probably have to pay at least some closing costs, which are generally about 2% of the price of the home. You'll also want to have an emergency fund with at least 3-6 months and ideally 6-12 months of necessary expenses. That's because the last thing you want is to lose your home to a foreclosure if an unexpected emergency makes it difficult to pay the mortgage.
An Insured Mortgage
You might be able to put down less than 20% by having your mortgage insured against default. One way to do that is with a government guaranteed mortgage. For example, the FHA loan program uses more lenient credit criteria than traditional mortgages, requires only a 3.5% down payment, and has the seller pay most of the closing costs.
Sounds pretty good, huh? Of course, there are costs to this. First, to qualify you typically need 2 years of steady employment with a stable or increasing income, a minimum credit score of 620 with no more than 2 30-day late payments over the last 2 years, no bankruptcies in the last 2 years, no foreclosures in the last 3 years, and a mortgage payment no more than about 30% of your gross pre-tax income. Second, there are limits on how much you can borrow based on where you live. Finally, you have to pay a premium of up to 1% of the loan amount at closing (it can be rolled into your mortgage but that would increase your monthly payments) and a monthly premium of up to .9% of the loan amount each year.
VA loans are another type of government guaranteed mortgage but only veterans on active duty in World War II and later periods are eligible. The loan limits are determined by the lender but generally max out at $417k except in certain high-cost counties. No down payment is usually required at all and there are no monthly premiums. However, there is a one-time funding fee of up to 2.4% that is reduced based on the size of your down payment.
Alternatively, you can get private mortgage insurance. The premiums can vary but are reduced the more you put down. The best part is that unlike with the government programs, the premiums can disappear altogether once you have 20% equity in your home, whether by you paying down the loan, the property rising in value, or (hopefully) both.
Confused? Don't worry about it. Your mortgage lender can help you decide which programs you qualify for and which one might be most beneficial for your situation.
In this scenario, you would get 2 loans. One would cover 80% of the home value and the other "piggyback loan" would cover the rest minus your down payment. The advantage is that you can avoid paying for mortgage insurance with less than 20% down. The disadvantage is that the piggyback loan has a higher interest rate and often has a "balloon payment" at the end. This is a final payment that's considerably larger than your normal payments so be sure to save up for it if you're going to keep the loan that long.
Using Your Retirement Accounts
Finally, there are several ways you can use retirement funds for a down payment. If you have an IRA, you can withdraw up to $10k penalty-free to purchase a home if you haven't owned one in the last 2 years. This is a lifetime limit for the total of all your IRAs so only use it if you must. If it's a Roth IRA, the earnings can also be withdrawn tax-free if the account has been open for at least 5 years (the contributions can always be withdrawn tax and penalty free). Otherwise, the withdrawals could be taxable.
If you have a retirement plan at work, you may be able to take a hardship withdrawal or a loan. A hardship withdrawal doesn't have to be paid back but it's taxable and subject to a 10% penalty if you're under age 59 1/2. A loan isn't taxable but must be paid back with interest. The good news is that the interest goes back into your account and the payments for a loan used to buy a home can often be spread over a longer time period than a regular loan.
The real cost of using your retirement accounts isn't the taxes or interest you pay but that those funds aren't growing for your retirement. The more aggressively you're invested, the greater that opportunity cost is likely to be. On the other hand, you have to weigh that against the value that owning a home can add as an asset that you can later sell or borrow against to help provide for your retirement.
The Bottom Line
If you want to take advantage of today's real estate market and record low interest rates but don't yet have the full 20% down payment, be sure to explore all of your available options. Figure out how much each option would cost you in mortgage premiums, interest rates, taxes, and lost investment earnings. Of course, you could always decide to stick with the tried and true old-fashioned method: save for it.
Are you looking for an unbiased answer to your own financial question? Once a week, we’ll be responding on this blog to questions from our Financial Helpline or posted on our Twitter or Facebook site.
Erik Carter, JD, CFP® is a resident financial planner at Financial Finesse, the leading provider of unbiased financial education for employers nationwide, delivered by on-staff CERTIFIED FINANCIAL PLANNER™ professionals. For additional financial tips and insights, follow Financial Finesse on Twitter and become a fan on Facebook.