Personal Finance

Home Loan Basics: Down Payment and Closing Costs

Apr 28, 2020

Misconceptions are common in our daily lives. Statements we accepted as fact often turn out to be incorrect. Albert Einstein failed his math class. George Washington had wooden teeth. You can't buy a home without a 20% down payment. All these statements are false.

Myths about Einstein and Washington may not affect your life, but misinformation about buying a home could prevent you from achieving an important personal and financial goal. If owning your own home is something you are striving for, don't let outdated and incorrect information hold you back.

It is time to dispel the misconception of a mandatory 20% down payment and explore the other options available to today's homebuyer. In addition, we will provide some helpful information on the other costs associated with buying a home.

What Is a Down Payment?

In its simplest form, a down payment is the money you pay upfront when you buy something on credit. It is the difference between the purchase price and your loan amount. Lenders view a down payment as a way to reduce their risk. After all, if borrowers are willing to use their own money to purchase a home, it's more likely they won't want to default and lose their investment. Plus, in the event the homeowner does default, the lender can limit the loss by not being responsible for the entire purchase price.

Typically, down payments vary between 3.5% to 20% of the purchase price of the home, and a few loan programs don't require any down payment at all. In 2019, the median down payment was 6% for the first-time homebuyer.

Alternatives to a 20% Down Payment

Although buyers can put down 20% or more as a down payment, many first-time homebuyers are looking for options at a lower percentage. Options can vary by lender and loan program, but here are some well-known programs that can help buyers avoid a large down payment.

Conventional Loan Programs — 3%

Conventional loans are a popular choice of many homebuyers. Guidelines for these loans are set by the government-sponsored enterprises Fannie Mae and Freddie Mac, but they are not guaranteed or insured by any government agency. Although some of the loans under this program require a 20% down payment, others require as little as 3%. For example, Fannie Mae offers a low down payment program called HomeReady®, which is available to both first-time and repeat buyers. Under this program, down payments can go as low as 3%. The Freddie Mac Home Possible® program is similar, also offering down payments of as little as 3% for first-time buyers, repeat buyers, and retirees.

FHA Loan Program — 3.5%

The most well-known option for low down payments is the FHA loan, which has been around since 1934. Unlike conventional programs, these loans are insured by the Federal Housing Administration (FHA), a part of the U.S. Department of Housing and Urban Development (HUD). Homebuyers enjoy down payments as low as 3.5% with the additional benefits of easier qualification and low closing costs. FHA loans are a popular choice for many first-time homebuyers.

VA Loan Program — 0%

The VA loan program has an option for no down payment. The increased risk to the lender is reduced under this program because the VA guarantees a portion of the loan. In addition to no down payment, VA loans also provide more favorable terms to buyers. However, eligibility for this type of loan is limited. Borrowers generally need to be active Service members, Veterans, or surviving spouses to be considered eligible for a VA loan.

USDA — 0%

The U.S. Department of Agriculture (USDA) offers home loan programs that don't require a down payment. The Section 502 Guaranteed Loan Program and the Section 502 Direct Loan Program help low- and moderate-income borrowers purchase homes in rural areas. Some loans are provided directly by the USDA Rural Development while others are financed through private financial institutions and guaranteed by the USDA.

Closing Costs

In addition to a down payment, there are other expenses that are associated with purchasing a home. These expenses are generally referred to as closing costs. Depending on the loan type, these costs can be paid by the borrower or the seller, or they can be rolled into the loan amount. When a loan is referred to as a no-closing-cost mortgage, the borrower doesn't pay the cost at the closing of the loan. Instead, the costs are added to the loan amount or traded for a higher interest rate. In this way, the closing costs are paid over the life of the loan instead of in one large sum.

The exact closing costs you pay depend on a number of factors, including the location of the property, the loan program used, the size of your down payment, and the lender you select. Three days after the lender receives your loan application, they will provide you with a Loan Estimate. In addition to estimated interest rate and monthly payment, it provides total closing costs. Then three days before your loan closing, you'll receive a Closing Disclosure with the final amounts of the closing costs.

Let's take a look at some of the common descriptions of these closing costs. We will break them down as they relate to your down payment, your loan itself, and the property you are buying.

Expenses Related to Down Payment

Depending on the type of loan you select and the amount of your down payment, you could be required to pay for a type of insurance that protects the lender or a fee related to the loan program.

Conventional Loan PMI

Private Mortgage Insurance (PMI) is provided by a private insurance company to protect the lender. In most cases, it is a requirement of conventional loans when the borrower pays less than 20% on their home purchase. The cost of PMI can vary based on factors such as the loan type, loan amount, and lender. It will most likely fall somewhere in the range of 0.5% to 2% of the total loan amount. Depending on the program, the amount to cover the insurance can be paid as a monthly premium, a one-time upfront premium, or a combination of the two.

FHA Funding Fee

Under the FHA loan program, borrowers will pay an upfront mortgage insurance premium (UFMIP) of 1.75% in most cases. They will also pay an annual amount that ranges from 0.45% to 1.05% — depending on the loan term, down payment amount, and loan amount. For example, if the borrower takes out a 30-year mortgage and puts 3.5% down on a loan amount of $350,000, the annual MIP will likely be 0.85% of the loan amount.

VA Funding Fee

In most cases, when you purchase your home through the VA program, you will pay a VA funding fee. This is a one-time fee that can be paid at the close of your loan or added to your loan amount. Because this fee varies depending on a number of factors, your lender will refer to the funding fee chart provided by the VA to calculate an exact amount. For example, when a borrower is purchasing their first home with no down payment, the chart reflects 2.3% of the total loan amount as the fee. In addition, there are some instances related to service and disability in which the fee can be waived.

USDA Loan Guarantee Fee

Generally, a borrower can expect two guarantee fees to be applied by the lender under the USDA loan program. One is an upfront guaranteed fee up to 3.5% of the total loan amount. The other is an annual fee of up to 0.5% for the life of the loan. Based on USDA guidelines, your lender will calculate the exact amounts of each fee for you.

Expenses Related to Your Loan

There are expenses that are specific to the loan process, securing an interest rate, and preparing mortgage documents. These fees vary by lender, loan product, and borrower. Below you will find some of the common names used for these fees with a short explanation of each. Some expenses may be for the same thing but called by a different name, depending on the lender. For example, an administrative fee, application fee, origination fee, and processing fee are all related to the processing of your loan. Generally, a lender will only apply one of these fees.

Administrative Fee: A charge by your lender to cover the expenses of processing your loan.

Application Fee: A charge by the lender to process your loan application.

Attorney Fee: In states where required, a charge by an attorney to prepare your home purchase documents.

Broker Commission/Broker Fee: The fee paid to a mortgage broker, if you choose to use one.

Credit Report Fee: A charge by the lender for obtaining your credit reports from Experian, Equifax, and Transunion.

Courier Fee: A fee to have a courier deliver loan documents.

Discount Points: A payment to the lender to reduce the interest rate on your loan.

Document Preparation Fee: A fee charged by the lender to prepare the legal documents required for your loan.

Lock Extension: A fee charged by the lender to extend the period of time your interest rate will be available, aka locked in.

Notary Fee: A fee to have a notary assist with the signing of loan documents.

Origination Fee: A fee charged by the lender to process your loan application.

Prepaid Interest: A charge by the lender for the accrued interest on your loan until your first payment.

Processing Fee: A fee charged by the lender to verify the information from your application and create the necessary documents for your loan.

Recording Fee: A fee charged by a government agency to record the purchase of your property.

Underwriting Fee: A fee charged by the lender to assess your ability to repay the loan.

Wire Transfer Fee: A charge to cover the expense of wiring funds.

Closing Costs Related to the Property

There are a number of common charges related to the property you are purchasing, with some slight variations depending on how your state assesses taxes.

Appraisal Fee: A charge for an appraiser to assess the value of the property and provide a report to the lender and you.

Flood Certification Fee: A charge to determine if the property is located in a flood zone. If it is, flood insurance will be required by the lender.

Home Inspection Fee: A fee you pay to have a professional inspection of the property before you purchase it.

Homeowners Insurance: The prepayment of the first year's insurance premium on the property.

Lender's Title Insurance: A one-time charge by the title company to protect the lender if a dispute should arise around ownership of the property.

Owner's Title Insurance: The premium for a policy that protects you if someone challenges your ownership of the new property.

Property Taxes: Your portion of the property taxes that are prorated to you based on the property sale date.

Transfer Tax: A tax by a government agency to transfer the title to the buyer from the seller.

Title Search Fee: A fee charged by the title company to review public records for any ownership issues related to the property.

Today, many borrowers achieve their dream of owning a home sooner through low down payment and first-time homebuyer programs.

A mandatory 20% down payment on a home is an outdated myth. There are a number of low down payment and first-time homebuyer programs available today. The VA loan program generally doesn't require any down payment. And the down payment requirement for certain FHA and conventional loan programs can go as low as 3.5% and 3.0%, respectively. In addition to learning about low down payment options, borrowers can also benefit from becoming familiar with the common closing costs connected to a home loan. Details of these expenses are available in the Loan Estimate form provided by the lender after an application is completed. The final amounts of these closing costs will appear in the Closing Disclosure form sent to borrowers three days before loan documents are signed.

You can rely on the experienced mortgage professionals at Axos Bank to provide the guidance and support you need when you are ready to explore home loan options. Call 888-546-2634 to speak with an experienced mortgage specialist today.