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If you’re planning to buy a home, you probably know that you should have some money to use as a down payment. While there are a number of ways to get a mortgage even if you have less than the ideal 20% of the purchase price to use as a down payment, you'll still need to put in some cash. And even a small percentage can translate to a large sum of money, as shown in the table below.
Down Payment as a Percentage of the Median-Priced Home Costing $234,000
Mortgages backed by the Federal Housing Administration allow for down payments as low as 3.5%. For a current median-priced home, that amounts to $8,190, far more than the average U.S. household has left over each year after paying their expenses. Home buyers might also need cash for closing costs, and to keep in reserve for future expenses. So where can you find all this money?
- Use Your Savings for a Down Payment
- Use Gifts from Family or Friends for a Down Payment
- Get Money for a Down Payment from Your IRA or Other Retirement Savings
Use Your Savings for a Down Payment
About 78% of first-time homebuyers tap personal savings for their down payment. If you’re in the process of saving up, you can tackle various categories of your normal expenses and try to pare them back. For example, if you’re currently a renter you might try to negotiate your lease or take on a roommate to free up some cash for a home purchase.
You should keep your down payment savings relatively liquid (meaning, in cash) and in a place you can access it on short notice. This might mean a savings account. While these accounts have been paying almost no interest for many years, an online search will lead you to a couple of options where you can currently earn about 1% per year on your money.
Other places to store your down payment are a bit riskier. Bonds often have limitations on how soon they can be cashed out or sold. Mutual funds and stocks are subject to the whims of the market, which could force you to sell at a bad time to make a home purchase. Still, about 9% of first time home buyers pull money from these kinds of investments for their down payment.
Use Gifts from Family or Friends for a Down Payment
The baby boomers have generally fared better than their offspring in financial terms, and some help their sons and daughters buy a home. About 27% of first-time home buyers get a gift from a relative or a friend. Most often, it’s from their parent.
Gift funds can trigger trouble for mortgage programs, some of which limit the amount that can come from someone else. But it might be perfectly acceptable, as long as the gift-giver and recipient follow the proper procedure. This may require, among other things, a down payment letter specifying the amount, the property address, the relationship, and that the amount is a gift, not a loan that needs to be repaid. Check with your potential lenders for specifics.
Get Money for a Down Payment from your IRA or Other Retirement Savings
If you’ve been making a concerted effort to save for retirement, you may get some bonus options when it comes time to buy a home. If you have been saving money in a Roth IRA, you can take your contributions out (but not your gains) at any time and for any reason with no taxes or penalties. This means you could use that full amount for a down payment on a house. The drawback is that you can never replace that money in your Roth IRA, though you can continue to make future contributions for as long as you’re eligible.
If you have a 401K plan or a 403B with a current employer, ask about your options in regards to a home purchase. Some of these plans offer loans, which you pay back with interest to yourself (win-win!). However, this kind of loan might affect your mortgage eligibility because it’s another required monthly payment, which changes your debt-to-income ratio. But any actual withdrawals from these accounts will be subject to tax and a 10% penalty. You might be able to get around the penalty by first rolling the money into an IRA.
You may be able to take up to $10,000 out of a traditional IRA or an SEP-IRA for a home purchase. Generally, you need to be younger than 59 and a half, and have not owned a home for the past two years. Also, that $10,000 is a lifetime maximum. You will pay tax on this money (because you haven’t yet), but you won’t pay the 10% early withdrawal penalty. If you are married, both you and your spouse can each take $10,000 out of an eligible account under these rules and conditions.
Once you’ve figured out your down payment, don’t forget the other big upfront expense when you’re buying a home: closing costs. You might also be required to have additional cash put aside for anticipated bills.
Buying a home is expensive, but living in your own home, which you can customize and control completely, ends up being well worth it for many people.