Buying a House? What to Know About Down Payments

April 7, 2022
Housing prices are rising, but the financial guidelines for putting together a down payment still apply.

How do you come up with a down payment in today's ultra-competitive housing market?

Existing home prices have been growing steadily—surging nearly 20% in 2021 alone1—leaving the median home price above $400,000 around the end of last year.2 That's nearly double what it was a decade ago. At the same time, the number of listings nationwide has been trending lower since at least 2016, according to data from Realtor.com.

Throw in years of relatively slow wage growth, reports of crazy bidding wars and homes selling for way over asking, and now a potentially steep rise in mortgage rates as the Federal Reserve battles inflation, and it's little wonder some would-be homeowners are sticking with their rentals. (That’s ok! Sometimes renting is the better option.)

That doesn't mean it's impossible to make the leap, but even in this historically inhospitable market, many of the traditional financial rules of thumb for buying a home still apply—including those on pulling together a down payment. Here, we'll review those guidelines and explore the tax and financial considerations behind some common ways of coming up with a down payment.

What can you afford?

Before you even worry about putting down any money, of course, you need to determine what you can afford.

"This doesn't just mean figuring out what kind of monthly mortgage payment you can handle," says Chris Kawashima, CFP®, a senior research analyst at the Schwab Center for Financial Research. "Think about how homeownership affects your overall financial health—will it keep you from saving for retirement or paying for a kid's education? Spending too much on a home can leave you feeling house rich and cash poor."

Use Schwab Bank's mortgage calculator to get a basic grasp on how much you’ll have to pay each month after accounting for your down payment. However, this isn’t likely to be the end of it. Keep in mind that you’ll also be signing up for years of maintenance.

"Don't make the mistake of thinking that because your mortgage payment may end up lower than your rent, that buying a home is going to be cheaper," Chris says. "There are additional costs like property taxes, home insurance, repairs and utility costs, landscaping, remodeling, etc. that will likely end up costing you more."

Assuming your other goals are on track and you're ready for the responsibility, here are two important financial metrics to understand:

What's your credit score?

In general, you'll need a credit score of at least 620 to secure a conventional mortgage, and higher scores can mean lower interest rates. If your score is lower than you'd like, take steps to improve it, such as paying bills on time and limiting how much debt you put on your credit cards. 

What’s your projected debt-to-income ratio?

You can use the 28/36 rule to get started. The idea is that your total housing costs—including mortgage principal, interest, taxes, hazard insurance and potentially homeowner association payments—shouldn't exceed 28% of your gross monthly income. All your debt combined shouldn’t exceed 36% of gross income. In both cases, the lower your debt-to-income ratio the better. 

Your down payment will obviously affect your debt-to-income ratio, as every dollar you can put toward the purchase of the home is one you won't have to borrow. In general, the higher your down payment, the easier it will be to qualify for a mortgage loan and negotiate the lowest rate. Also, the more you agree to put down, the more competitive your offer may be, as financing can be a key consideration when sellers are reviewing multiple offers. That doesn’t mean you should stretch, though.

Making your down payment

Ideally, you want to aim for at least 20% down—which, if we use the median home price of more than $400,000, could mean $80,000. (And that doesn't even include closing costs.) Otherwise, your lender will probably require that you carry private mortgage insurance (PMI). If that happens, you'll have to pay monthly PMI premiums on top of your mortgage payments until your loan-to-value ratio—which compares the size of your mortgage to the value of your property—reaches 80%.

While this may not be a dealbreaker, there are a few things to know. PMI protects the lender—not you—if you stop making payments on your loan. And it can be expensive (more than 1% of your loan balance per year, depending on how much you borrow and your credit score). Additionally, PMI can skew your debt-to-income ratio, potentially to the point where it affects your ability to qualify for a mortgage.

One last thing: When you're applying for a mortgage, you'll need to show that you have enough assets to cover more than just your down payment. Your lender may also have a reserve requirement, meaning liquid assets you can use to make mortgage payments after you've put down your down payment. Usually, they want to see two months' worth of assets, but it can vary.

So, after taking all that into account, what if you can't do 20%?

You can put down less

If you can handle the extra cost of PMI, this can be an option. FHA loans, which are guaranteed by the Federal Housing Administration, allow first-time buyers to put down as little as 3.5%, with PMI. VA loans (available to active-duty members of the military, veterans, and some family members) are available for no down payments and no PMI. You can also put down less for conventional loans or carry a second mortgage (a "piggyback" loan). However, it's crucial to understand that putting down less means you’re going to have a lot more debt and larger monthly payments.  

One potential upside is that if you put down, say, 15%, and the value of your home rises swiftly, your loan-to-value ratio could hit 80% quickly. If your mortgage servicer allows, you could get another home appraisal to remove PMI. However, before scheduling an appraisal, you should contact your servicer to see if this is an option, as there may be a two-year minimum requirement for keeping PMI on the loan.

Assistance is available

First-time buyers may also have access to a variety of federal, state, and local programs offering grants or special no- or low-interest loans to cover the cost of a down payment. This can help lower your loan-to-value ratio, as you won’t have to borrow as much, and if your monthly payments are within the 28%/36% debt-to-income guardrails mentioned above, this can be a decent option. Just make sure dodging a down payment doesn't tempt you into getting more house than you need. Also be aware that some assistance programs require that you repay what you receive, or even live in the house for a certain period.

Coming up with the cash

Saving and investing

If you've been planning for this and are ready with 20%, well done! As long as your debt-to-income ratio looks good and your finances are in order, go forth and conquer.

If you're still a couple years out and concerned about the way prices and interest rates are moving, resist the temptation to take more risks with your investments. Money that you'll need soon or can't afford to lose shouldn't be in the stock market—it's better to invest it in relatively stable assets, such as money market funds, certificates of deposit (CDs), or Treasury bills. Delaying your purchase may be a better approach than chasing risky returns.

Family loans or gifts

Many first-time buyers get a little help from their families. The benefits of gifts are undeniable: You can hit your down payment target easier, and immediately lower your loan-to-value ratio. Family members who give you money can also take advantage of the annual gift tax exclusion of $16,000 per person ($32,000 for married couples). Of course, gifts can be larger than that amount, but anything over the limit will count against their lifetime estate/gift tax exemption amount of $12.06 million per individual, or $24.12 million per couple, in 2022. (If they've already hit their limit, the gift could be taxable.)

Loans are more complicated. Even though this is an intra-family affair, the IRS requires certain formalities such as a signed written agreement, a fixed repayment schedule, and a minimum interest rate, otherwise they will assume the loan was a gift. You might consider having an attorney draw up the paperwork. And to avoid future family fights, it’s essential that everyone is clear about their intentions regarding the repayment.

Your lender may also require a written agreement, and will take the repayment terms into account when deciding whether you qualify for the mortgage, as a loan will impact your debt-to-income ratio. Family members may also have to document the source of any gift or loan to verify it is from their savings, and not a separate loan they took out to help you.

"Don't forget: If you're borrowing for your down payment and a mortgage, you'll end repaying two loans," Chris says. "Borrowing a down payment could also get in the way of saving for your other goals. And, if you ever get into financial trouble and you need to do a short sale or face foreclosure, the bank will get its money before your family does, which can strain your relationship."

Cashing out stock awards

A grant of company stock or stock options can also be a source of cash for a down payment. However, the tax rules for such grants can be complicated. It would be a shame to sell off a lump of stock to make your down payment, only to be hit by a huge tax bill when you file your return for the year. Employers are required to withhold only a minimum amount for taxes. If you are planning to sell appreciated stock, talk with a tax advisor about setting aside enough additional cash to cover the eventual bill.

Also be aware that if your stock options or restricted stock aren't fully vested, they're not going to help you put together a down payment or qualify for a loan. "Underwriters are going to look at assets that are liquid or can be readily liquidated: What stock is available to sell now?" Chris says. "If it's all 'promise' in the form of options or restricted stock that vest in the future, they will not be considered eligible assets, including for any reserve requirements." 

Borrowing from your retirement savings

Many 401(k) plans allow you to take out loans against your savings, but this should really be your last resort. Loans from a 401(k) are limited to one-half the vested value of your account or a maximum of $50,000—whichever is less. However, even though you're borrowing from yourself, it's still a loan you'll need to repay with interest (generally one or two percentage points above banks' prime rate). And when you pay yourself back, it'll be with after-tax dollars that will be taxed again when you eventually start drawing from the account in retirement. If you don't pay yourself back, it'll be considered a withdrawal subject to income taxes and a 10% penalty.

Another issue is that if you take a loan against your 401(k), your plan administrator may not allow you to make any additional contributions until you’ve repaid what you borrowed. That could set your retirement plans back.

What about IRAs? First-time homebuyers can withdraw up to $10,000 from an IRA without incurring the 10% early-withdrawal penalty, but ordinary income taxes apply if it is from a tax-deferred traditional IRA. For Roth IRAs, you can withdraw your contributions (i.e., the principal) at any time without tax consequences. However, complications arise if you want to tap the account's earnings or if the Roth assets are from a conversion. We recommend consulting with a tax professional before withdrawing those types of assets.

1Source: S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index.

2Source: U.S. Census Bureau and U.S. Department of Housing and Urban Development, Median Sales Price of Houses Sold for the United States, retrieved the Federal Reserve Bank of St. Louis.

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