With a booming economy and comfortably plump market in the Fox Valley IL, there are many more first time homebuyers flooding the market. So I thought it fitting to start a few blogs for those less familiar with how buying a home works, I mean, lets face it, even if you’ve been buying homes for 20 years, the process doesn't get less confusing. So, lets start at the beginning; naturally, the Down Payment.
Let’s discuss what a Down Payment IS and IS NOT.
Definition of Down Payment
For a home buyer, the Down Payment, from here on out referred to as the DP, IS the sale price minus the mortgage loan amount. It IS NOT the same as the buyer’s cash outlay (the two are often confused). They are different by the amount of settlement costs charged to the buyer.
For example, if the price is $100,000, the settlement costs $5,000 and the buyer has cash of $30,000, the amount available for down payment is only $25,000.
Thus why many home buyers pay a higher interest rate in exchange for a lender rebate that will cover some or all of the settlement costs.
The DP IS NOT the same as the owner’s equity, except on the day of the purchase. Owner equity is what the owner could potentially net from selling the property. Where as the down payment is a one-time measure as of the purchase date, owner equity changes month by month. It will rise above the down payment as the mortgage loan balance is paid down and as the market value of the house rises, due either to property improvements or to market changes. AND obviously the owner equity could also decline if house prices fall…remember 2008?
Why are down payments necessary?
Basically to protect the lender. You risk losing your down payment if your home ends up in foreclosure, so it's a way to make sure you make your monthly payment obligations.
Minimum down payments
Most mortgage lenders require a down payment of at least 3 percent. FHA loans (mortgages insured by the Federal Housing Administration) require a down payment of at least 3.5 percent. Depending on your credit history, the type of dwelling and your reason for buying, the minimum down payment could be 5 percent, 10 percent, 20 percent or more. This is why it makes sense to shop around for a mortgage. Use your Real Estate Agent as a resource. They will be able to help you find a few different mortgage options.
When you make a down payment of less than 20 percent, your only option is to also buy mortgage insurance. There are two main types:
Private Mortgage Insurance (often called PMI), is paid to an insurance company. You will pay what are called annual premiums, which you will most likely pay monthly and most insurers also offer the option of an "upfront premium", in which you make a big payment at the beginning of the loan.
FHA insurance is paid to the federal government. When you get an FHA-insured mortgage, you will pay an upfront premium AND monthly premium payments.
In many cases, lenders charge fees for down payments of less than 20 percent. Those fees will be on top of mortgage insurance premiums. Usually, the smaller the down payment, the higher the fee. These fees will be paid at closing, FYI. Sometimes the lender will charge a higher interest rate instead of fees.
Options For Down Payments:
Appraised Value VS Sale Price
A big questions I get, is whether in the case where the appraised value is higher than the sale price, the difference can be counted as part of the down payment? From the lender’s perspective, the answer is “no”. The property value used in determining the down payment is the sale price or appraised value, whichever is lower. The one and only exception to this is when the seller provides a gift of equity to the buyer (usually a family member). In these cases, the lender acknowledges that the house is being priced below market and will accept the appraisal as the value. In most of these cases, Lenders will require two appraisals and then they will take the lower of the two.
Land as the Down Payment
Another big question is if land purchased as part of a plan to construct a new home can be used as down payment? The answer is “yes” actually. However, the land is then valued based on how long it has been held. If the owner has held the land for a long time, the lender will appraise the completed house on the lot and the difference between the appraisal and the cost of construction will then be viewed as the down payment.
So, if a builder charges $160,000 for the house and the appraisal comes in at $200,000, the land is assumed to be worth $40,000. A loan of $160,000 in this case would have a down payment of 20%.
However, if the land was purchased recently, the lender will NOT value it for more than its purchase price. If the price was only $30,000, for example, the lender will value it at $30,000, and the down payment will only be 15.8%.
Down Payment and Mortgage Insurance
From the borrower’s perspective, a larger down payment means a lower mortgage insurance premium. For example, a home purchaser with a good credit score who puts 3% down on a conventional loan will pay a monthly mortgage insurance premium about twice as large as the premium on an otherwise identical loan with 5% down, and 4 times as large as the premium on an otherwise identical 15% loan with 20% down.
I know, still a bit confusing, but that’s why we’re here, this is what we do! If you need help navigating the murky waters of first time home buying, give The Rullo Team a call, we'd be happy to help you get into your first Fox Valley home. The best way to buy a home will always be to find a good Realtor you trust and then let them do all the hard work and remember don’t be afraid to ask questions if you need things clarified. If your Agent doesn’t encourage you to ask questions…find another Agent.
Not ready to talk to an agent yet? Then check out some of the FREE Home Buyer Tools we offer.