Is it wise to make a down payment lower than 20 percent?

Right along with having a steady employment history and a strong credit score, many potential homeowners strive to save up for a 20 percent down payment before they sit down with a lender. Unfortunately, quite a few families and individuals fall short of that benchmark. 

Luckily, there are several options for people who want to buy a home, but don’t have the most robust savings. In fact, the Federal Housing Administration (FHA) offers a loan that only requires a down payment that’s 3.5 percent of the home price. And some lenders, such as the Navy Federal Credit Union, are offering no money down mortgages.

However, there may be a few risks associated with this tactic. Keep reading to learn more about some of the potential disadvantages of putting less than 20 percent down on a home.

Higher Interest Rates and Monthly Payments

When you come to the table with a lower down payment, you may qualify for a less favorable interest rate, says Jennifer Hayden, loan originator at Gateway Funding Diversified Mortgage Services, LP. The reason? Hayden notes that when you pay less cash up front, lenders consider your loan to be higher risk, and higher risk borrowers are often subject to higher interest rates - as much as a half of a percentage point.

While a slightly less favorable interest rate may not seem like the worst thing in the world, keep in mind that it means you’ll be paying more money each month. Not only that, but with all other factors being equal - the lower your down payment, the higher your monthly payments will be since you need to borrow more money. And a higher monthly payment may be the last thing a cash-strapped new homebuyer needs.

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Take a look at the following two scenarios for a homebuyer who is taking out a 30-year fixed rate mortgage for a $250,000 home. We'll compare the monthly payment on a loan with 10 percent down at 4.5 percent interest, with a loan that has a 20 percent down payment and 4 percent interest rate.

Even with a down payment of just $25,000 more and an interest rate that’s .5 percent lower, a homeowner can save about $185 on each monthly payment - which adds up to more than $40,000 over the lifetime of the loan.

Risks Associated with Having Low Equity

If you make a small down payment on your new house, you’ll begin your home ownership journey with a limited amount of equity. Why is low equity a big deal? Well, for one thing, you’re at a higher risk for being underwater on your mortgage, says Hayden.

What exactly does this mean? Well, when you owe more money than your home is currently worth, your mortgage is underwater or upside-down. And as the official site of the National Association of REALTORS®, Realtor.com, notes, this situation can make it difficult for a homeowner to qualify for a traditional refinance in the future. That means that if interest rates do happen to drop lower in the future, you'll have a harder time refinancing to a lower rate.

This low equity can also affect your outlook for selling your home.

“If someone purchases a home with a small down payment and then needs to sell the home in a couple of years, there is the possibility that they will owe more than what they are offered for the house,” Hayden points out.

If this happens, homeowners could be in the difficult position of having to come out of pocket to pay the difference between the value of the home and the amount of money owed to the lender, according to the Federal Reserve Bank of Cleveland. If a homeowner can’t afford this difference, he would have to sell his home at a loss, be forced to stay in the home, or he might face foreclosure, notes the Cleveland Fed.

Mortgage Insurance Requirements

Monthly mortgage payments can already be enough of a burden. But if you put down less than 20 percent for your down payment, you will typically have to pay mortgage insurance on top of your regular monthly payments.

This insurance protects the lender if a buyer forecloses on a home. And while mortgage insurance costs differ, Realtor.com reports that this insurance typically amounts to 0.5 percent of your home loan amount annually.

That means that if you were required to pay mortgage insurance at 0.5 percent for a $250,000 loan, you'd be paying an extra $104 per month. When you put that on top of the higher mortgage payments and increased interest we mentioned earlier, things can truly get pricey for a homebuyer without a substantial down payment.

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Advantages of a Low Down Payment

While there can be risks associated with paying a low down payment, there are also several benefits.

Perhaps the most obvious advantage is that potential homebuyers can still get into a house with a low down payment. This is especially beneficial for homeowners who have consistent monthly bills, which makes saving up for a 20 percent down payment out of reach. And with FHA loans available at just 3.5 percent down, potential homebuyers can rest easy knowing that homeownership is attainable.

What's more, home prices are increasing at about 6 percent per year, says Joe Parsons, senior loan officer at PFS Funding and writer at The Mortgage Insider.

And with interest rates on the rise, it could get pricey to put off buying a home while you wait to save enough for a 20 percent down payment.

For example, taking a 6 percent annual home price increase into account, if you put off purchasing a $250,000 home for one year, you would pay $265,000 one year later, and $280,900 two years later - for the same house.

As a result, if home prices continue to rise, you may find yourself out of reach of the 20 percent mark anyway, or settling for lower-priced homes in order to reach that goal.