Purchasing a home with low or no money down

One of the biggest hurdles when buying a home is acquiring enough money for a down payment. Conventional loans from lenders require a 20% down payment or more for the purchase of your home. On an average single family home in Seattle ($600,000), a 20% down payment is $120,000, an amount many buyers don’t have access to. There is a common misconception that “20% down” is required to purchase a home. Luckily, there are alternatives to conventional loans.

Is low or no money down a good option for you?

Let’s face it, coming up with $120,000 can be difficult. Paying low or no money down on a purchase of a home does have some downsides such as paying PMI (private mortgage insurance). Think of PMI as a bank’s insurance for you having “less skin in the game”, or less of your money involved in the purchase. Generally, when you have less than 20% down, you will need to pay PMI.

Is PMI bad? Not necessarily so. It’s a necessary evil, but doesn’t last forever. Assuming you’ve purchased your home and pay PMI, once your home’s market value reaches less than an 80% Debt-to-Value, you are entitled to stop paying PMI.

An example: You purchase your home for $450,000 with $0 down payment, thus your mortgage is $450,000 Your home’s market value increases by 5% year-over-year for 5 straight years. Your new home value is $574,000. Your new Debt-to-Value ratio is now $450,000/$574,000 = 78%.

$0 down: VA loans

The VA loan is a no-money down loan available to US military service members and surviving spouses.

These loans are guaranteed by the US department of Veteran Affairs meaning if the home is foreclosure, the government would still be on the hook for the mortgage.

Some of the benefits of VA loans are: You may have intermittent occupancy, past foreclosures or bankruptcy do not affect your qualification, and you do not have PMI payments.

VA loans are straight forward and are similar to FHA loans and guidelines (which we’ll cover later).

3.5% down: FHA loans

The FHA loan is a bit of misnomer. It doesn’t actually issue loans, but insures them. When the bank underwrites your loan, the FHA has certain requirements to insure that loan against loss.

FHA loans are famous for their lenient credit score requirements (just 500) and low down payment of just 3.5% of the purchase price.

From my experience, this is a more traditional route for low down payment most buyers choose.

10% down: 80/10/10 “piggyback” loan

The 80/10/10 loan is typically reserved for those with above average credit scores because you will have 2 separate loans. The “80” of this loan is the primary mortgage on the home which will cover 80% of the purchase price. The remaining “10” and “10” are covered by a line of credit from your new home (HELOC) and the cash for down payment. HELOCs are adjustable rate loans against your home where the loan is similar to a credit card. You can pull out money up to a predetermined limit. Because of the creative structuring ability of this loan, lenders love the flexibility it gives.

Word of caution

When purchasing a home with little or no money down, you must be conservative with your analysis and numbers. If you’re planning to buy your home as an investment, you need to find better deals than those who invest normally. It means you need to dig deep to find the hidden gem deals. High cash flow or added value investments are essential. Because you are purchasing with little or no money down, your ratio of loan payments vs rent will be significantly higher as this is the cost of having no skin in the game. On the other hand, you also have less to lose because less of your own money is at stake.

Of course, with little of your own money in the home, your return will be exponentially greater with any cash flow or appreciation of the home. High risk is high reward.

An example: You purchase a home for $700,000, 3.5% down payment (~$25,000). In 5 years, your home is worth $1,000,000 and you’ve accumulated $300,000 in appreciation. Your return on your $25,000 cash invested is 1200%.

In a similar scenario, except, you purchase a home for $700,000 with a 20% down payment ($140,000). Your return on your $140,000 cash would only be ~200%.

Don’t deplete your entire life savings

It’s important to understand that “life” happens. You have a medical emergency and can’t work for an extended period of time. Need to buy a new car. Your roof collapses. And as every home owner will tell you, emergencies are bound to happen and living life without a back fund is no fun indeed. Insurance can sometimes help you in these situations, but not every time.

This is why it’s important to be able to cover your monthly payments comfortably. Don’t focus on the down payment. Focus on the mortgage payments. Conservatively, if you don’t have an emergency fund, it’s better to reserve less for a down payment to have more in the bank for emergencies. Living house-poor is not fun.

Plan worst case scenarios

Plan for the future of your home/investment. This means planning for the worst case scenario. Be conservative with your estimates and plan for any major maintenance items such as a new roof or plumbing or electrical systems. If you’re planning to rent out the bedrooms or separate units, plan for higher than expected vacancy. Plan to purchase the property only if they pass the stress test using your conservative numbers.

Although the analysis side of the real estate transaction is beyond the scope of this post, I highly recommend you, the reader, spend time to learn or hone your skills on how to evaluate investment properties and whether if it makes sense to purchase or not.

Summary

Be conservative, buy great deals, and have a sound financial backup plan. Don’t spend every last dime on buying a home. Living house poor is not fun! If it means working a second job or saving a bigger chunk of your monthly income, do it! Maybe it means asking your manager for a raise or lowering your monthly living expenses. Whatever it is, get as soon as possible! Stop with the excuses of “I can’t…” and instead think “How do I…”. Getting from point A to point B is not necessarily the end result, instead, what matters is the path we take.

If you haven’t already, please visit some of my other blog posts. I really recommend the current investment series about the capital gains exemption and the 1031 exchange.

Wishing everyone the best and happy investing.