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Many homebuyers struggle to afford a down payment on a house and need to find alternative funding. However, using a personal loan to cover your down payment is generally not a good idea. Instead, people purchasing homes should consider other financing options including FHA loans, alternative lenders, down payment assistance programs and various other options that are less costly or less risky than personal loans.
Is Using a Personal Loan for a Home Down Payment a Good Idea?
Most times, using a personal loan for a home down payment isn't an option. Mortgage lenders generally don't allow personal loans to be used and prefer you not to obtain a down payment from another lending institution. Using a personal loan defeats the purpose of the down payment contribution, since the payment is supposed to show that you're investing some of your money. It raises the question for lenders of whether you're able to afford the house if you can't afford the down payment. That said, it's possible to get a personal loan for down payment if your mortgage lender agrees and you have no other options.
A personal loan is a last resort option if you have exhausted all other alternatives. In addition to your monthly mortgage payments, you'll have to pay the lender principal and interest each month for a personal loan until you pay off the entire balance. Typically, personal loans have shorter terms than mortgages. Monthly payments tend to be higher since it has a shorter period. So, the money that you'll be saving from not paying a down payment will be short-lived, and you'll have missed the other options to pay a low down payment or even a zero down payment.
Homebuyers are required to disclose the source of their down payment with records and bank statements. Lenders review your credit report and usually require that the money you have in the bank for the down payment is "seasoned," meaning that it has been sitting in the same bank account for a certain amount of time before you purchase the house. It's required because you can't take out a bank loan and put it in the account without the lender's knowledge. A personal bank loan—which appears on your credit score after 60 days—will usually lower your score because of the hard inquiries on your credit report and the addition of new credit, which mortgage lenders don't want to see.
The Disadvantages of Personal Loans
Personal loans are unsecured debt, meaning there's no collateral for the bank to collect if you default on the loan. Lenders will charge much higher interest rates to make up for the fact that the loan is not backed by anything. Not only are interest rates high, there are plenty of other disadvantages to consider when taking out a personal loan:
- Defaulting with the addition of a personal loan if you're unprepared for the monthly costs.
- Increasing your debt-to-income ratio.
- Mortgage lenders may reject your loan request due to taking out a personal loan.
- High monthly payments with both a personal loan and mortgage.
- Lenders are less likely to grant you the mortgage amount you need.
- For each loan application, a hard credit pull is done. This lowers your credit score, making it more difficult to be approved for a loan.
How to Get a Personal Loan for Your Home Down Payment
While we don't recommend taking out a personal loan, if your mortgage lender agrees to accept a personal loan as the source of your down payment, shop around for the best rate. Find the general interest rates that you qualify for, as well as the best options for your situation. Credit unions and online lenders generally offer better interest rates than traditional banks. Try to look for the lowest interest rate possible, because you'll need to pay your monthly mortgage bill as well.
If you use a personal loan to pay for your down payment, make sure that you have enough money for closing costs. Technically a personal loan can cover both your down payment and closing costs, but this defeats the purpose of these payments and your debt-to-income ratio will likely increase. If you can't afford both the down payment and the closing costs, you should probably reconsider whether you should buy a house because you'll need to pay high monthly costs for the personal loan and mortgage.
Other Mortgage Options
A common misconception homebuyers have is that they need to put down 20% of the loan value for the down payment. Often times, it's recommended but not necessary. Instead of taking out a personal loan to fund your down payment, consider these mortgage alternatives with zero or low down payment options:
- FHA Loans
- VA Loans
- USDA Loans
- Alternative Lenders
- Conventional Loans
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FHA loans only require 3.5% down, if you have a credit score above 580. Although, if you put down less than 10%, you have to pay mortgage insurance premiums—a fee that protects the lender if you default—for the life of your loan. FHA loans are government-insured mortgages that make buying a home accessible to people with low income or poor credit. In order to qualify, you need at least two established lines of credit, a debt-to-income ratio that doesn't exceed 31%, and no "delinquent" federal debts including loan defaults or unpaid taxes.
VA loans are backed by the Department of Veteran Affairs and require no down payment. To qualify for this loan, you must be a veteran, on active duty, or an eligible surviving spouse. Unlike conventional mortgages and FHA loans, borrowers are not required to pay mortgage insurance and monthly payments tend to be low. This is probably the best option if you qualify.
USDA loans are for people looking to purchase homes in eligible rural areas. They require no down payment, unless the borrower has significant assets. Almost 97% of the geographic United States is eligible, you can check if your area qualifies by using a tool on the USDA's website. There are two types of loans available, the Guaranteed Housing Loan for the average income borrower and the Direct Housing Loan for low-income families.
There are multiple lenders offering zero or low down payment mortgages including a few traditional banks and many online lenders. These lenders include Quicken Loans, SoFi, Flagstar Bank, Bank of America, Suntrust, and PNC Mortgage. However, due to the low down payment, your monthly payment will probably be quite high, so make sure that you have enough money to cover those payments for the life of your loan.
Conventional loans offer down payments as low as 3%, but you must pay private mortgage insurance (PMI) until your payments reach 20% of the loan amount. If you're able to put 20% down, then you won't have to pay monthly private mortgage insurance. These loans follow the standards set by Fannie Mae and Freddie Mac. You can use them to buy your primary residence, second home, or rental property.
Alternative Options to Finance Your Home Down Payment
In addition to mortgage options, there are additional ways to finance your down payment without taking out a personal loan, these include:
- Down payment assistance programs (DPA)
- Piggyback loans
- Gifts from family or friends
- Saving up funds
- Retirement fund loans
Some DPA programs provide grants or gifts that don't have to be repaid and are often available to first-time homebuyers and existing homeowners. Many programs are state-based and you can look through the U.S. Department of Housing and Urban Development (HUD) website for offerings in your state or call your local government. There are other programs run by nonprofits, such as the National Homebuyers Fund, to help fund your down payment.
A piggyback loan—also known as a purchase money second mortgage—is when a borrower takes out two mortgage loans at the same time, one that's for 80% of the home's value and the other to make up the 20% down payment. It's used by homebuyers that don't have 20% down, but want to avoid paying private mortgage insurance. The most common piggyback loan is the 80-10-10—the first mortgage is for 80% of the home's value, a down payment of 10% is paid by the buyer, and the other 10% is financed in a second trust loan at a higher interest rate. Essentially, the buyer just puts 10% down and avoids paying PMI, but may have higher interest rates.
Gifts from Family or Friends
If you're unable to get assistance from a DPA program or a piggyback loan, you can ask a family member or friend if they'd be willing gift your down payment. Although this form of payment is usually accepted by mortgage lenders, there are strict rules for the process. First, you must check with your loan officer that they accept these gifts. Then, you must document the gift process, which must be given through check or wire transfer. The gift cannot be in cash or loaned and you must provide the receipts showing the transfer of funds. If you fail to follow these rules, you may not be able to use the funds or the gift could be counted against you as debt.
Save Up Funds
There are multiple ways to save for your down payment instead of taking out a personal loan. You can sell items you don't need, get a second job, ladder CDs, or just set aside part of your income each month. By selling items you don't need, you get rid of clutter while gaining money. You can also work part-time, freelance, etc., and save up the money you generate from those jobs. Laddering CDs is low risk but tends to have low returns. The simplest way would probably be to set aside part of your income each month into a savings account. You'll need to make sure that you can save enough for the down payment.
Retirement Fund Loan
Borrowing from a retirement account is not recommended, but if you really need the funds and don't want to increase your debt-to-income ratio, then it's an option. Some retirement funds have rules against borrowing, so check with your account. Each retirement account has different limits for the amount of money you can take out, and whether you'll be taxed on the withdrawal. Since you'll be borrowing from yourself and not a bank, you have many repayment options. You should only do this if you're certain that you can pay back the loan.