Choosing the Right Loan and Right Down Payment

At first glance, it may seem as though large down payments and short loan terms are the key to saving money on a mortgage, but each of these decisions has its own benefits and shortfalls. We can help you put them in perspective so you can make the best choice with respect to your circumstances.

Deciding on a loan and down payment amount for your upcoming home purchase isn’t always easy. Several factors can impact which loan program you can, or should, use. Understanding options early on is a great way to save time and be sure you start the loan process in the right direction.

Finances And Credit

With so many types of loans and down payments available, how do you know which one is right for you? Start by being honest with yourself about your finances.

How much money do you have saved to put toward the down payment and closing costs? Keep in mind that you need to save about 3% of the cost of the house for closing expenses. While you won’t need a down payment for VA and USDA loans, you will typically need a 3.5% down payment plus closing costs for FHA loans, and 5 to 20% down plus closing costs for conventional loans.

Have you taken care of your credit? If your credit score is less than 620, you will not qualify for a conventional loan. If it is less than 740, your conventional loan interest rate will be higher than it could otherwise be.

FHA requirements allow someone with a lower credit scores to purchase a home, as do other government-backed loans. Regardless of the loan program, a higher credit score is always better – so do what you can now to ensure you have the highest score possible when it comes time to obtain your mortgage loan.

Timing

Government-backed loans may require more paperwork or inspections than conventional loans. Because of this, they could take slightly longer to process. If you need to move in a hurry, Government-backed loans may present unwanted challenges. Remember that missing or out-dated paperwork is one of the top reasons for loan delays – so stay on top of your documentation with the assistance of your loan officer to ensure a smooth closing.

Savings and Opportunity Costs

You may have a 20% down payment saved along with closing costs, but do you really want to spend it now? For conventional loans, you can put 20% down and avoid private mortgage insurance (PMI), or you can put as little as 5% down with PMI. Let’s look at an example to understand the costs and benefits of these two programs in more detail. For this example, we’ll consider these two options when purchasing a $250,000 home using a 30-year fixed rate loan at 3.5%.

Option 1: A 20% down payment ($50,000) results in a $898 monthly mortgage payment which includes principal and interest.  No mortgage insurance is required because the down payment is equal or greater than 20%.

Option 2: A 5% down payment ($12,500) results in a $1,167 monthly mortgage payment which includes principal, interest and mortgage insurance (which is $101 monthly).

Most people look at the monthly payments and say that obviously, they would want to pay less per month, so they would choose the first option. However, let’s look a little closer. In order to save $269 a month, you would have to reduce your savings by $37,500. At $269 a month savings, it will take you 139 months—almost 12 years—to recoup this money. That’s a lot of time to live without a substantial nest egg.

Then you have to look at opportunity costs. What else might you want to do with this money if it weren’t tied up in your house? Perhaps you’ll be asked to be a bridesmaid in a wedding and won’t want to have to refuse because you can’t afford the dress. Perhaps someone will have a destination wedding in Puerto Rico, and you won’t want to have to decline because airfare is not in the budget.

Maybe you’ll have the opportunity to buy the sailboat you’ve always wanted at a steal, and having that money in the bank will allow you to bring your dream to fruition. Maybe the money would be better off earning interest or making a great return on investment in the stock market. No matter what, that $269 a month savings has an opportunity cost, and you need to consider that when making a decision.

Length of the Loan

Should you apply for a 15-year or a 30-year mortgage? After looking at the numbers, most people agree the substantial savings in interest that comes with a 15-year mortgage makes it an attractive option. In reality, affording a 15-year mortgage is more difficult and may result in being house poor, meaning that you can afford your house but nothing else.

Think of the opportunity costs associated with selecting a shorter term loan with a higher payment: A higher monthly housing payment results in less funds for investments, smaller retirement accounts and less resources to support a growing family.

Also consider how long you intend to stay in the home. If you feel confident that you will remain in the home for years to come, then a shorter loan might be worth the interest savings. On the other hand, if you plan to move on quickly, it might be better to use the monthly savings that comes with a longer term loan towards other things, even if it means simply saving the money for your next move.

If you aren’t sure, you can always go with a 30-year mortgage and make the larger payments of the 15-year schedule by paying extra payments to your principal. In this way, you can have the benefits of a shorter loan but still be able to go back to a 30-year schedule if funds get tight or your financial situation changes. Remember that in these cases, once you pay money into your mortgage you need to “ask” for it back by applying for a new loan or second mortgage to access the equity.

With so many options available, it is important to compare rates and programs to determine which combination works best for you. At today’s low rates, you are sure to find many good choices so it is hard to go wrong!