By Sarita Harbour
Is 5 percent down too low?
If you've been thinking about purchasing a home with a low down payment of just 5 percent or less, you aren't alone. According to a recent report from LendingTree, the average down payment for 30-year fixed rate mortgages dropped to 15.73 percent of the home's value in 2013's third quarter - 2.74 percentage points lower than in the second quarter of this year.
While that rate may seem low already, you may be surprised to find out that there are mortgages available that require just 5 percent down or in some cases, even less.
"The 5-percent-down mortgage isn't something new to the market," says Dan Gjeldum, senior vice president of mortgage lending at Guaranteed Rate, a mortgage company.
Wondering if these low-down mortgage options are a smart choice? We asked mortgage experts from across the country what they think. Their answers may surprise you.
What are the risks of a 5 percent down payment?
Less Equity: One important factor to consider when making a small down payment is equity, which is the value of homeownership represented by the house's value minus the remaining mortgage amount. Since a low down payment means that the mortgage amount is larger, the homeowner has less equity in the house. And lower equity could spell higher risk, especially when real estate values fluctuate.
If during that time the value of a home drops, homeowners who have low equity face the risk of financial loss. The concern is that they have borrowed more money than they will get when they sell the house. As a result, the homeowners would have to come up with funds to pay the lender the shortfall between what they owe on their mortgage and what they got for their house.
Of course, homeowners can manage the risk by planning to stay in the home for a long time, avoiding the need to sell it in a depressed real estate market, says Tim Paynter, a Colorado attorney and real estate investor.
Higher Monthly Payments: Putting down 5 percent or less also means a homeowner will have a larger mortgage and therefore a higher monthly payment than someone who has put more money down. As a result, there's added pressure to make sure that the homebuyers' income is stable and substantial enough to support making those high payments each month.
Some homebuyers who want to put only 5 percent down may also be drawn to an adjustable-rate mortgage (ARM) because of its comparably low interest rates. The interest rate is set for a specific period of time - from one to seven years - but after that time, it then adjusts to prevailing rates within certain boundaries. When the rate increases in an ARM, the mortgage payment could also increase. As a result, borrowers with large mortgages and low down payments may struggle to meet higher mortgage payments.
What are the costs associated with putting only 5 percent down?
Higher Interest Rates: If you're considering putting down 5 percent or less, be prepared to pay higher interest rates and additional costs that aren't required for higher down payment mortgages.
"The lower the down payment, the higher the risk of default and the higher the interest rate charged to the homeowner," says Bennie Waller, professor of real estate and finance at Longwood University in Virginia.
Since a low down payment means a larger mortgage and more potential for a default on the loan, there's more risk for lenders, leading to higher interest rates for these borrowers. And the higher interest rate isn't the only expense.
Private Mortgage Insurance: "The less you put down means the loan is going to be more expensive," Gjeldum says. "When you put less than 20 percent down, you may be required to pay for the additional cost of mortgage insurance." Gjeldum explains that private mortgage insurance (PMI) protects the bank issuing the mortgage in case the homeowner defaults on the mortgage.
Typically, PMI is .5 percent to 1.5 percent of the mortgage, according to the Federal Reserve. For example, if you buy a $300,000 house and make a 5 percent down payment, you're borrowing $285,000. If the PMI rate is 1 percent, the annual insurance premium if $2,850, which is divided into 12 monthly payments of $237.50. So while PMI is based on the property price, it is not cheap, says Waller.
What type of loans are available with a 5 percent down payment?
There are several options available to people who want to use a low down payment.
"You can get conventional mortgages with as little as 5 percent down," says Gjeldum. "FHA [Federal Housing Authority] allows 3.5 percent, and VA loans allow you to do 0 percent down."
The Department of Agriculture's Rural Development program also offers loans with 0 percent down for potential homeowners looking to puchase a home in rural area.
Grace Keister of Irvine California's First Team Real Estate advises those interested in buying a home to consider the potential benefits of a low down payment mortgage and whether or not it could outweigh the drawbacks.
"It will take you longer to pay off than [with] a larger down payment, but it will get you into a home sooner," she says. "This means tax deductions on your mortgage payments, instead of rent money going down the drain."
Who should consider a 5 percent down payment?
Who's a good candidate for a 5 percent down mortgage? According to Paynter, we all could be.
"Everyone should take advantage of low down payments when they can find these kinds of loans," he says. "As a general rule, this applies to those who have a stable income, who get a fixed interest rate, and who don't need to sell at a particular time," says Paynter.
Keister agrees. "If you are financially responsible, there is no such thing as a down payment that is too low," she says. "So long as you budget your money and continue working hard, you are a good candidate for a low 5 percent down payment."
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