Down Payments for First-Time Home Buyers

by J. M. Pressley
First published: January 26, 2008

Prices and rates may be dropping, but it's still daunting for the first-time home buyer trying to find money for a down payment. There are a number strategies or programs designed specifically to help them.

If there is any good news coming out of the U.S. housing market lately, it will be a boon for home buyers in the near future. Falling prices and lower mortgage rates will offer more purchasing power for those who can afford it. The bad news is that lenders will likely be more wary in making loans than they were years past. The potential for marginal credit ratings and high debt-to-asset ratios could make it even harder for first-time buyers to procure affordable financing. An important part of the equation is the down payment.

Most lenders—especially in the wake of the sub-prime market collapse—are not simply going to lend a prospective buyer 100% of the purchase price. The down payment can be viewed as protection for both the lender and buyer. For the lender, it provides at least some collateral in hand should the buyer default on their mortgage. For the buyer, it provides instant equity in the home while reducing lifetime loan costs. The standard rule for years was 80/20: 80% loan, 20% down payment. The 20% is still a key figure, as it allows the buyer to avoid the extra cost of private mortgage insurance (PMI) on top of the loan.

As housing has substantially increased in value over the last two decades, however, that 20% down payment has been harder to produce for the first-time buyer. The median American home value in 1990 was $101,100; by 2000, it had risen to $119,600, and by the end of 2005, it had jumped to $213,900 (U.S. Census Bureau, National Association of Realtors).

Take a moment to think about that. A buyer in 2000 would have had to garner nearly $24,000 for a down payment at the median value. Just five years later, that down payment would have to be almost $43,000. Not so much of a problem for existing homeowners with equity or for the independently wealthy. But for an average first-time buyer, that kind of cash is difficult to have in hand. Many find themselves asking how they can afford 10% or even 5% down.

Fortunately, there are ways to find money for a down payment. By taking advantage of strategies or programs designed specifically to help them, first-time home buyers have options available. With some careful planning, even 20% might not be beyond reach.

Savings

The down payment, like it or not, begins with personal savings. Prospective buyers should start saving early, setting aside what they comfortably can, well before they're ready to own. There are also ways to maximize that money as it accumulates. Find a good money market or short-term CD with above-average yields. The most important thing is to preserve that principal, so risk is to be avoided. Starting from scratch, $300 a month for three years at a 3% interest rate comes to over $11,300 to put down.

Family Gifting/Loans

If the opportunity presents itself, family members can individually gift up to $12,000 (or $24,000 for a married couple) in a given year with no tax consequences to the donee. While that gift isn't tax-deductible for the donor, it's a viable estate planning technique that reduces potential estate taxes. The other benefit of gifting from immediate family is that the lender won't factor that amount as additional debt burden when determining the buyer's loan eligibility.

If a loan from family is more palatable than an outright gift, buyers should keep in mind that the lender will consider any amount borrowed as additional debt burden that factors into eligibility. A private loan, even from a family member, must be repaid in the view of the lender. On the other hand, these loans tend to be more generous and flexible in their terms. Personal finances will dictate whether or not a loan from family will detract from the buyer's overall lending profile.

Tapping Retirement Funds

Conventional wisdom says that retirement savings are untouchable. Under the right circumstances, however (such as a long retirement horizon), borrowing against a retirement plan may be a viable option. If the buyer has a 401(k) or 403(b) plan that allows for loans, federal law allows for the lesser of $50,000 or half the vested account balance. For vested balances under $20,000, the buyer may borrow the entire vested balance to a maximum limit of $10,000.

Although each employer sets the specific terms according to the plan rules, the benefit to these loans is that home buyers are repaying themselves. Of course, the loan is generally tied directly to one's employment with the plan sponsor; in the event of departure or termination, any remaining loan balance could come due immediately.

Another potential source is an Individual Retirement Account (IRA), which allows for a penalty-free, lifetime withdrawal limit of up to $10,000 for the purchase of a home. Income taxes may apply on the withdrawal, which must be used within 120 days of receipt or returned to the IRA.

Partnering

Depending upon the circumstances, a co-buyer could make a large difference in the buyer's ability to purchase a home. The buyer can either find a housemate who intends to share the cost and live on the premises, or an investor who simply provides cash consideration for a portion of interest in the home's value (like a silent business partner). In any event, the buyer is advised to consider the arrangement's full legal and financial ramifications before entering into any binding agreement.

Assistance Programs

First-time home buyers have quite a few governmental and nonprofit assistance programs available to them. At the federal level, the Federal Housing Administration and other agencies such as the Veterans Administration offer mortgage assistance specifically designed for people like first-time buyers who might have trouble qualifying for conventional mortgages.

Each state also has an agency that focuses on affordable housing. Most of these programs focus on either reducing the initial down payment necessary to keep the interest rate down, or they offer flexible terms on secondary loans to provide or supplement the down payment. There are generally some income provisions attached to these programs.

Sources

Bankrate.com, Nolo, The Motley Fool, Yahoo! Finance