For many homebuyers, the biggest hurdle to clear before buying a new house is coming up with a down payment.
Traditionally, buyers aimed to put down 20% to avoid private mortgage insurance (PMI), which increases their monthly payments. But for many—especially those early in their careers and paying off student loans—socking away $40,000 to buy a median-priced home is not a reality.
Instead, homebuyers overall contribute far less—10% on average last year. First-time homebuyers specifically put up even less, 5% on average. Fortunately, there are mortgages designed with small down payments in mind. "The choices dried up for a while," says Pava Leyrer, chief operating officer of Northern Mortgage Services in Michigan. "But lending has loosened up. There are many more options now."
Here's what's out there.
Small down payments
FHA: Mortgages backed by the Federal Housing Administration require only 3.5% down, and that money can be gifted to you from a relative, close friend, charity, government agency or employer. FHA loans have more lenient credit standards and debt-to-income requirements, a plus if you have a lower credit score. The minimum FICO score is 580.
FHA loans come with two mortgage insurance fees. First, there's a one-time mortgage insurance premium equal to 1.75% of the loan. You don't have to pay the fee upfront; it can be wrapped into the loan, along with other closing costs. The second fee is the annual mortgage insurance premium that you must pay for the life of the loan. It's added to your monthly payment. How much you pay ranges from 0.45% to 1.05% and depends on the loan amount, the size of your down payment, and the duration of the loan. If you want to get rid of the annual mortgage insurance, you must refinance into a new loan.
"You're probably going to refinance or move in five to 10 years, so buyers shouldn't get hung up on that," says John Stearns, a senior mortgage originator with American Fidelity Mortgage in Wisconsin.
Conventional loan: Both Fannie Mae and Freddie Mac back fixed-rate and adjustable-rate mortgages that require just 3% down or 5% down with a minimum credit score of 620. The down payment can also be a gift or qualified subordinate loan. There are income limits per geographic area, but they are flexible for high-cost areas. Borrowers also must take an online education course about sustainable homeownership. Another disadvantage: Closing costs—typically 2% to 5% of the purchase price—can't be added to the outstanding loan amount, and instead must be paid upfront by the buyer.
The key advantage is how the PMI works. Unlike an FHA mortgage, you can request to have the loan's PMI dropped once you think you have 20% equity in your home. The lender will order an appraisal to find out. But once your home equity reaches 22%—based on the purchase price or appraisal, whichever is lower—the PMI is automatically eliminated by law, says Stearns.
No down payment
VA: A home loan backed by the Department of Veterans Affairs "is the best loan out there, bar none," says Scott Sheldon, branch manager of New American Funding in California. Available for active and retired service members and surviving spouses, it requires no down payment and no PMI. There is one odd requirement: The home must pass a pest report.
National Guard and Reserve members also qualify if they served at least six years or 90 days on active wartime duty. The VA also limits the total amount you pay in closing costs. There is a 2.15% funding fee for your first VA loan with no down payment; it goes up to 3.3% for a second loan. The fee is reduced if you put down at least 5%, which can also be wrapped into the loan amount.
USDA: The U.S. Department of Agriculture also guarantees a no-down payment mortgage on the purchase of a primary residence. The house must be located in a USDA-designated area, and you must meet certain income limits based on geographic area. The USDA loan does come with PMI, but it's extremely low, says Sheldon, about 70% lower than an FHA mortgage.
"If someone is eligible for this loan,"Sheldon says, "it's a very viable product to purchase with a lower payment."
Down payment help
Many state housing finance agencies, local governments, employers and nonprofit organizations offer grants or loans to help beef up down payments for eligible homebuyers in their communities, says Leyrer.
For example, California will lend up to 3.5% of a home's value to be used toward the down payment or closing costs. The payments are deferred for 30 years, meaning the borrower doesn't have to repay the loan until they pay off the first mortgage. Massachusetts is going a step further, and in March began offering actual mortgages that allow low- and middle-income homebuyers with good credit to finance 100% of the purchase of their first home.
But it can be tough to find existing programs because they change often, says Leyrer, who also noted that many include fees or higher rates to help finance the program. "No one gives out free money. You're paying somehow," she says. It's smart to ask a mortgage professional about these options, so you can adequately compare them.