The myth that you need to put 20% down to close on a home is a left-over idea from a couple of generations ago (the introduction of FHA loans in 1934 waived this requirement).
But the thing about a myth – when financial experts, well-meaning parents, college professors, and even real estate professionals think that it’s true, the myth survives.
Today’s home buyers are the unfortunate recipients of wrong information
The simple answer is yes; you can buy a home for less than 20 percent down.
In fact, you shouldn’t even be paying such a massive upfront cost for your home. According to the National Association of Realtors, the average down payment for first time home buyers is just 6 percent.
You need 20 percent down to avoid mortgage insurance with most conventional (non-government) loans
If you make a down payment of less than 20 percent, your lender requires you to buy private mortgage insurance or PMI. This protects the lender from losing money if you end up in foreclosure. PMI also is required if you want to refinance your mortgage with less than 20 percent equity.
But as many homeowners have discovered, PMI is not a bad thing and can even help you save money in the long run.
You’ll still need to pay the closing costs
Closing costs usually range from 1-4% of the home’s purchase price. Several factors are at play – lender fees, property taxes, and escrow fees. But there are ways to help with the closing costs, such as getting a line of credit, and you can also negotiate with the seller for seller concessions.
Some mortgage types even allow you to pay for your closing costs through down payment assistance programs. This is offered by the government and several non-profits.
So why is it better to not put 20 percent down?
Besides for PMI being a good investment, this also gives you breathing room to invest elsewhere. Why deplete your 401k when you can continue to hedge your bets in case of a setback? Leave your retirement funds intact. Removing funds for a down payment severely limits compound interest you could have earned and you’ll also lose out on inflation.
In case you lose your job, you can also use that downpayment money so that you can fund your next steps. Never tie up liquid assets in something as money-losing as a home. Remember, your home is your home, not some speculative investment.
And just in case the housing market goes south…
You will have less equity in the home if you make a small down payment. Less equity means that if your home loses 30 percent of its value, you’ll still have the cash-on-hand instead of the bank.