3 Steps to Choosing the Right Down Payment

You know you should be saving for a home, but how much will you need? In this post, we detail how to set an appropriate goal and strategic plan to put down the optimal down payment on a home.

  • Understanding Down Payment Options
  • Set Strategic Goals
  • Plan for Special Considerations

Down Payment Options

Whether you’re purchasing a primary residence, second home, or an investment property, it’s critical that you understand the impact of different down payment options before signing a contract. The amount of the down payment you choose to make will likely impact both your interest rate and monthly payment. Putting more money down means that you have more skin in the game, which often results in a more favorable interest rate.

Just because putting more money down will improve your rate, there are certain scenarios in which it may benefit you to take a higher loan amount and keep more money in the bank. Before discussing those specific considerations, let’s set strategic goals for how much you need to save.

Set Strategic Goals

Generally, it is common to aim for saving an amount equal to 10-25% of the purchase price for down payment. However, if you value a quicker path to owning, you may invest as little as 3-3.5% depending on the type of loan you are targeting

Consider how different down levels affect your total monthly payment obligations, the interest rate you will secure and the additional cost of mortgage insurance which could be triggered if you choose to put down less than 20%.

The good news is that mortgage insurance companies are becoming more competitive with the pricing of their lender paid single premium products, borrowers with less than 20% down and a strong credit profile can typically obtain financing with very small impact to rate, and no requirement to pay monthly mortgage insurance payments. 

You could wait until you’ve saved a higher percentage of the purchase price, say 20% of a $500,000 home or $100,000. This scenario will carry a lower interest rate and you would not be required to pay monthly mortgage insurance, which could save you hundreds of dollars per month.

Then we have jumbo loans- which are triggered when financing exceeds the limits set by the Federal Housing Finance Agency (FHFA). If you are looking to secure a loan amount that just barely exceeds the FHFA limits in your county, you may want to consider putting down a slightly larger amount to reduce the loan amount to fall inside of the FHFA limits. There may or may not be a benefit to this approach depending on where the rate environment is at that point in time. 

Although historically interest rates on loans securitized by Fannie Mae and Freddie Mac are lower than jumbo interest rates, there are many times where the rate environment favors the jumbo loan category. It’s important to ask questions and understand the relationship between jumbo and non-jumbo rates at the time you are looking to secure your mortgage to make sure that you making the best long-term financial decision.

Once you define your timing and spending parameters, there are additional items to account for during the planning process.

Not sure how much home you can afford? Use our easy calculator to find out.

Plan for Special Considerations

Now that you know a little bit more about how down payments impact your situation, and what amount you plan to save,, let’s talk through where the down payment money may be coming from.

Lenders understand that all of the down payment funds may not be coming directly from your savings account.  You may choose to take a distribution or loan from your 401k, you may be looking to pull funds from your investment accounts, or you may be receiving ‘gift funds’ from a family member.  If you are going to go the route of a distribution from your 401k, or will be receiving gift funds, it’s important to understand if you will incur any penalties for doing so, or whether there may be any IRS impact (tax implications) to receiving that gift.   

You will also want to carefully consider the impact of taking a distribution from your investment account.  If your wealth manager is consistently generating returns of 8% and the interest rate environment is in the 4-4.5% range, it may make sense to keep that money in the account and put less money down on the home, even if that means accepting a slightly higher interest rate on your mortgage. 

Remember that when your lender is determining your loan eligibility, it’s not just your credit score, income, and down payment amount that factor in, lenders may also want to understand that you have asset reserves post-closing. If a lender tells you that they want to see that you have 12 months of reserves, they will be multiply 12 by the amount of your total monthly housing payment (including property tax, insurance, and mortgage insurance, if applicable). The reason they do this is to ensure that if you experience loss of income or loss of employment, that you have a cushion saved to cover your mortgage payments for a period of time until you can make the necessary adjustments.   

You may also want to consider how your income is trending. Do you expect your income to increase or decrease? If you intend to make more over time, a higher monthly payment may be more beneficial than depleting your savings. Conversely, if you expect your income to stay constant or even decline, a lower monthly payment might be more helpful down the road and you may choose to put more money down upfront.

Set a safety net for yourself, an amount you want to preserve in savings, that makes you feel comfortable in the event that something major happens in your life. If a major financial event were to happen, you will sleep better knowing that you are not house rich and cash poor. Spend time assessing your current situation and the likelihood of such an event happening to you, and make sure you plan accordingly.  Making the decision to use all of your assets for down payment might seem like a good idea at the time but could put you in an uncomfortable position down the road if something were to happen.

Choosing the Right Down Payment

Consider all the factors mentioned above and decide what’s most important to you. Set your down payment goals and work backwards using your unique timeline. Know that it’s almost impossible to try and anticipate interest rate trends and where rates may be if a you decide to wait to purchase in order to save additional down payment funds.

Continuously ask yourself the question: “If I were to buy today, with less money down, do I feel good about the price that I’m paying for the home, do I feel strongly that home values will appreciate, and is the monthly payment comfortable and within my means?” 

If the answer to those three questions is yes, than waiting to save more money may in fact not be the right answer.