Having a decent down payment on a house can reduce how much you need to borrow and the interest you’ll pay on the mortgage. It can also potentially qualify you for a lower interest rate.
If you don’t have enough cash on hand for a big down payment, you might think about using a personal loan. But in general, mortgage lenders don’t allow the use of personal loan funds for a down payment. Also, having a personal loan on your credit report can affect your ability to qualify for the amount you need for the mortgage.
Here’s why personal loans usually aren’t an option if you need a down payment and which alternatives are available.
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Why a Personal Loan for a Down Payment on a House May Not Work
A mortgage is a lengthy financial commitment, both for you and the lender. The more money you borrow, the riskier it can be for the lender if you ultimately stop making payments, even if it’s years into your mortgage.
The primary purpose of a down payment is to reduce the risk for the lender. In fact, if you’re getting a conventional mortgage and don’t put down 20% or more, you may be required to pay private mortgage insurance, which protects the lender’s interests if you default on your debt.
Using a personal loan for a down payment may sound like a logical solution if you’re low on cash, but don’t expect it to work in your favor.
“If you are using a conforming loan, Fannie Mae and Freddie Mac do not allow a personal loan to be used for a down payment,” says Casey Fleming, a San Jose, California-based mortgage advisor and author of the book, “The Loan Guide: How to Get the Best Possible Mortgage.” “It’s a deal stopper.”
Even if you manage to persuade a lender to accept personal loan funds on a nonconforming loan, you could still run into problems, including:
— Taking out a personal loan for a down payment may suggest that you’re unable to afford homeownership. The lender could increase your interest rate or deny your loan altogether.
— Personal loans are typically unsecured, which means the lender making the personal loan has no recourse on that debt if you default. This could make you a riskier borrower, and it may mean lenders won’t offer you a personal loan for mortgage use, or they’ll charge a higher interest rate than you’d pay otherwise.
— Personal loans have much shorter repayment terms than mortgages, and the monthly payment could be difficult to manage.
— Having a personal loan on your credit report increases your debt-to-income ratio — the amount you spend on monthly debt payments divided by your gross monthly income — which could reduce the mortgage amount you qualify for.
— A recent influx of cash in your bank account may raise questions with your lender.
All things considered, it’s best to avoid using a personal loan for a down payment on a house. Even if a lender allows it, it could cause more problems than it solves.
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Can You Get a Loan for a Down Payment?
While personal loans are typically a no-no for home down payments, mortgage lenders don’t rule out other types of loans.
Piggyback loan. A piggyback loan, also sometimes called an 80-10-10 loan, makes it possible for homeowners to avoid private mortgage insurance if they put just 10% down.
In this scenario, the first mortgage is for 80% of the sale price, and a home equity loan or line of credit of 10% piggybacks on the first. You’ll then contribute 10% of the sale price as a down payment.
For example, if the sale price is $250,000, you’d take out a mortgage for $200,000, a second mortgage for $25,000 and put down $25,000 in cash.
Depending on the situation and the lender, you may also be able to do a piggyback loan where you put down 15% or 5% and use the second loan to make up the difference.
“Sometimes (a piggyback loan) is a better strategy for long-term debt management, too,” says Fleming. “For instance, if you have occasional windfall income, such as stock options, you can use an equity line as a second mortgage and use the windfall income to pay down the loan quickly. Then, if you need the cash, you can access it again because it’s an equity line.”
One major drawback to doing a piggyback loan is that it may be difficult to refinance down the road. Also, the second loan may come with a variable interest rate, which can increase over time.
401(k) loan. You’re allowed to borrow from your 401(k) for a down payment, and the monthly payments won’t count against you in your debt-to-income ratio like a personal loan would. But there are some potentially serious consequences if things don’t go as planned.
As far as how much you can borrow, you’re limited to the greater of $10,000 or 50% of your vested account balance, with a total maximum of $50,000.
So let’s say you have an account balance of $30,000 that’s vested, which means if you left your job today, you’d take that amount with you. In this case, you’ll be limited to borrowing $15,000, which might not be enough for what you need.
Using your 401(k) for a down payment loan may sound appealing. But if you leave your job for any reason, you’ll need to pay back the loan by the due date of the current year’s tax return. So if you’re laid off or find a new job in December, you’ll have about four months. If, however, you leave your job in January, you’ll get more than a year.
If you default on a 401(k) loan, it’ll be treated as an early distribution and be subject to income taxes and a 10% penalty.
It’s also likely that you’ll miss out on potential earnings in your retirement account.
[Read: Best FHA Loans.]
Alternatives if You Can’t Put Down 20%
If you’re intent on becoming a homeowner and aren’t sure when you’ll have enough cash for a decent down payment, here are some options.
Loans with low down payment requirements. One of the easiest ways to avoid a down payment is to apply for a loan that doesn’t require much money down, if at all.
“A lot of people count themselves out because they have that idea of 20% stuck in their head. If a house they’re interested in costs $200,000, they think they’ll never be able to save $40,000, so they give up on the idea of buying the house,” says Phil Shoemaker, chief business officer at Home Point Financial, a wholesale mortgage lender. “But in reality, they might only need to bring $6,000 to the table, a much more manageable number.”
Many conventional lenders, for instance, offer mortgages with a minimum down payment of 3% of the sale price, and some even require no down payment at all from certain types of borrowers.
It may also be worth considering government-insured mortgages. The U.S. Department of Veterans Affairs and the U.S. Department of Agriculture both offer home loan programs with no down payment requirement. And if your credit score is 580 or higher, you may qualify for a Federal Housing Administration loan with a down payment of at least 3.5%.
Just remember there’s a trade-off when you’re not making a 20% down payment. You’ll likely pay PMI and more interest over the life of the loan.
Down payment assistance programs. Several down payment assistance programs exist nationwide to help you get the money you need to get into a home. In many cases, this money is considered a grant, which you don’t have to pay back as long as you meet certain conditions.
Others may come in the form of a deferred loan that may be partially or fully forgiven if you remain in the home for a set period. Check with your state and local governments to see what programs are available and whether you’re eligible.
Gifts from family and friends. Many mortgage lenders will allow you to use gift money as a down payment.
“A lot of times, a borrower will get money gifted to them by parents or grandparents to apply to the down payment,” says Shoemaker, “and the lender will collect documentation on it to ensure that it’s a gift and not just a loan.”
Personal savings. While not the most exciting option, waiting until you’ve set aside enough to put money down may be a better choice in the long run. If your budget is tight, saving for a down payment can take a while, so it’s important to stay on top of your spending and look for areas to cut back.
You may also consider finding other ways to make extra money and put windfalls, including any tax refunds, holiday gift money and bonuses from work, directly into your savings account.
Savings isn’t the only indicator of whether you’re ready to buy, though. Market timing, housing needs or changes in your budget may become more important factors than your down payment.
“Rent is expensive and just keeps going up,” Fleming says. “People get married, have babies, suddenly get promotions and raises, and find themselves getting killed on taxes. All these life events can be catalysts for buying a house. If you are ready due to life circumstances, it may be much wiser to buy now.”
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