Getting enough cash together for a home purchase has been a major stumbling block for many would-be home buyers. But it’s less a problem today than it used to be, thanks to new loan programs and changes in the law.
You certainly will need some cash to make a down payment and cover settlement costs — how much will depend on the loan/lender you choose and the terms of your contract with the seller. You’ll also need to budget cash for moving expenses, new appliances and furniture, decorating costs, perhaps even immediate repairs or remodeling.
Although a 20% down payment is still considered “standard” in the lending industry, home buyers frequently purchase with much less. Most lenders will accept lower down payments, say 10%, if buyers purchase private mortgage insurance (PMI) to shield the lender from the higher risk associated with the loan. Often, an initial premium is paid at the settlement table, with additional premiums paid monthly. Other payment arrangements are available, however. (If you buy PMI, you can have it canceled when your equity in the home reaches 20% or more, either through payment on principal or market appreciation.)
The Federal Housing Administration (FHA) offers loans to qualified buyers with as little as 3.5% down. Veterans can take advantage of no-down-payment loans from the Department of Veterans Affairs (VA). And zero-down loans are now being offered by conventional lenders for home buyers with excellent credit, though the interest rate on these loans may be somewhat higher.
Whether you decide to make a large or small down payment will depend on the amount of cash you have available and your financial goals. Some buyers prefer to make larger down payments to minimize their monthly payments and interest expense. Other buyers make small down payments because they lack cash or they want to “leverage” their investment (watching their homes appreciate on OPM, other people’s money). The low-down-payment strategy also yields a higher mortgage-interest tax deduction.
Settlement costs (also called closing costs) cover a variety of expenses including:
- Loan or discount points
- Loan origination or service fee
- Loan application fee
- Credits report
- Home inspection
- Title insurance (lender’s and buyer’s)
- Attorney or settlement agent
- Recording fees and transfer taxes
- Prepaid interest
- Prepayments for taxes and insurance
You may also pay other costs, not listed above, depending on the particular transaction. Some of these costs are typically thought of as sellers’ costs, while others are often paid by buyers, with different traditions about who pays which in different areas of the country. Regardless of local tradition, however, you may be able to negotiate to have the seller pay some or all of your settlement costs. You may also be able to reduce your cash outlay by rolling your settlement costs into your mortgage loan.
Of the settlement costs listed, loan or discount points (paid to reduce your interest rate on the loan) may be the largest expense. If, for example, you pay 2 points (a point equals 1% of the loan amount) to reduce your interest rate by 1/4% on a $100,000 loan, you’ll pay $2,000 for points at closing. If you pay all of the other closing costs in cash as well, you could need an additional $3,000 or more.
Your lender will give you a Good Faith Estimate of closing costs within three days of your loan application. It is, however, an estimate — the actual numbers will differ somewhat by the time you get to settlement.
If you negotiate to minimize your cash requirements but you still don’t have enough to purchase a home, there are a number of creative options available. Of course, a disciplined savings plan is the first strategy you should consider. Here are a few other ways you can assemble the cash you’ll need:
- First-time buyers (defined as those who haven’t purchased a home in the past two years) are allowed to borrow up to $10,000 from their individual retirement account (IRA), penalty free, if the money is used to purchase a home. The $10,000 can also come from parents’ or grandparents’ IRA accounts.
- Borrow from a company pension plan or against a life insurance policy.
- Get an advance on a future inheritance.
- Ask parents or other benevolent individuals for a tax-free gift, accompanied by a “gift letter” indicating you will not be required to repay the gift.
- Partner with others (friends, relatives, investors), to exchange their cash for equity in your home (which you can buy out later, if you wish).