The main reason to scrape the cash together for a large down payment is to reduce the size of your monthly payments. Also, if you've got your heart set on a specific house or price range, but your income isn't high enough to take out a big loan, a larger down payment can make up the difference. Here are other benefits to making a large down payment: * No PMI. No PMI. If you pay 20% of your purchase price, you don't have to pay private mortgage insurance, or PMI, which lenders routinely require of homebuyers who borrow more than 80% of the home's value, to protect the lender if you default. If you pay 20% of your purchase price, you don't have to pay private mortgage insurance, or PMI, which lenders routinely require of homebuyers who borrow more than 80% of the home's value, to protect the lender if you default.* Smaller monthly mortgage payments. Smaller monthly mortgage payments. If you borrow less money, you'll have less to pay back, leaving you more cash for other things. If you borrow less money, you'll have less to pay back, leaving you more cash for other things.* Less interest overall. Less interest overall. If you borrow less, you'll owe less in total interest. For example, if you got a 30-year, fixed rate loan for $200,000 and paid 6.5% interest, you'd pay approximately $255,090 in interest over the life of the loan. But you'd pay only about $204,070 over the life of a $160,000 loan with the same terms. The bank would get over $51,000 more in interest just because you didn't put $40,000 down at the beginning. If you borrow less, you'll owe less in total interest. For example, if you got a 30-year, fixed rate loan for $200,000 and paid 6.5% interest, you'd pay approximately $255,090 in interest over the life of the loan. But you'd pay only about $204,070 over the life of a $160,000 loan with the same terms. The bank would get over $51,000 more in interest just because you didn't put $40,000 down at the beginning.* It's like money in the bank. It's like money in the bank. No matter what the market does, putting cash into your home is a low-risk way to use it. No matter what the market does, putting cash into your home is a low-risk way to use it.* Lower interest rate. Lower interest rate. Borrowers who take out mortgages for more than a certain amount ($417,000 in most places in 2009, but it is higher in high-cost areas and can change annually) get what are called "jumbo" loans, with higher interest rates. If making a down payment will lower your loan to below that amount, your interest rate will probably drop, too. Likewise, if you're a borrower with poor credit, you might be able to obtain better loan terms if you fork over more cash at the beginning-the lender figures you've got more incentive to keep paying if you stand to lose your down payment when the lender forecloses. Borrowers who take out mortgages for more than a certain amount ($417,000 in most places in 2009, but it is higher in high-cost areas and can change annually) get what are called "jumbo" loans, with higher interest rates. If making a down payment will lower your loan to below that amount, your interest rate will probably drop, too. Likewise, if you're a borrower with poor credit, you might be able to obtain better loan terms if you fork over more cash at the beginning-the lender figures you've got more incentive to keep paying if you stand to lose your down payment when the lender forecloses.

Where Will I Get Down Payment Money?

If you're interested in making a down payment but haven't saved the cash, here are some alternative sources:* A gift or loan from family or friends. A gift or loan from family or friends. If you have a loved one with available cash, you may be able to get a low-interest loan, or even a gift. According to Asheesh Advani, president of Virgin Money, over 30% of first-time homebuyers get help from friends and family-either as a gift or a loan-for the down payment. If you have a loved one with available cash, you may be able to get a low-interest loan, or even a gift. According to Asheesh Advani, president of Virgin Money, over 30% of first-time homebuyers get help from friends and family-either as a gift or a loan-for the down payment.* Withdrawal from your IRA. Withdrawal from your IRA. You can withdraw up to $10,000, penalty-free, from an individual retirement account (IRA) to purchase your first home. Your spouse or cobuyer can do the same. For more information, see IRS Publication 590, You can withdraw up to $10,000, penalty-free, from an individual retirement account (IRA) to purchase your first home. Your spouse or cobuyer can do the same. For more information, see IRS Publication 590, Individual Retirement Arrangements (IRAs) Individual Retirement Arrangements (IRAs), available at www.irs.gov.* Borrow from your 401(k). Borrow from your 401(k). Check with your employer or plan administrator about whether you can borrow from your 401(k) plan. Also ask how much you can borrow (usually, $50,000 at most). For more information, see IRS Publication 575, Check with your employer or plan administrator about whether you can borrow from your 401(k) plan. Also ask how much you can borrow (usually, $50,000 at most). For more information, see IRS Publication 575, Pension and Annuity Income Pension and Annuity Income, available at www.irs.gov.* Current assets. Current assets. If you have other investments, like stocks or bonds, consider cashing them out-but be sure to factor in the taxes you'll owe. If you have other investments, like stocks or bonds, consider cashing them out-but be sure to factor in the taxes you'll owe.* Don't have a big wedding! Don't have a big wedding! Okay, we're half joking here. But you wouldn't believe the number of couples we've met who said that, in retrospect, they wish they'd kept the wedding small and put that money toward a house. Okay, we're half joking here. But you wouldn't believe the number of couples we've met who said that, in retrospect, they wish they'd kept the wedding small and put that money toward a house.

Make a 30% down payment. According to Nigel, "When Olivia and I decided to buy a house together, we were earning nonprofit salaries (low). But our parents were excited to see us settle down and gave us generous gifts. Between that and emptying our savings account, we had about 30% to put down-which convinced the seller to choose our bid from among the many others, because we'd obviously have no trouble financing the rest. Now we have absurdly low monthly payments-less than we'd be paying in rent-and the house has appreciated in value. Also, we're in a position to help our parents out financially, if they need it." According to Nigel, "When Olivia and I decided to buy a house together, we were earning nonprofit salaries (low). But our parents were excited to see us settle down and gave us generous gifts. Between that and emptying our savings account, we had about 30% to put down-which convinced the seller to choose our bid from among the many others, because we'd obviously have no trouble financing the rest. Now we have absurdly low monthly payments-less than we'd be paying in rent-and the house has appreciated in value. Also, we're in a position to help our parents out financially, if they need it."

However, all these benefits don't mean you should put your every last dollar into a down payment. There are some perfectly good reasons to make a down payment under 20%, or even no down payment at all. For many people, saving up one-fifth of the price of a house sounds laughable. (Think about it-that's $80,000 for a $400,000 home.) And when home values are on the rise, waiting to save 20% can prevent potential buyers from building equity now now, make homebuying more expensive or, in the worst case, pricing them out of the market entirely.

And even if you have the cash for a down payment, you might prefer to use it for other things. For example, when interest rates are low, some people finance their homes with low-interest loans, then use their cash to fund other, more lucrative investments.

Borrow it all and then some. Ben was about to get a promotion. "I was excited," says Ben, "until I realized that I'd no longer qualify for the government-assisted, low-interest loan I'd been counting on-my salary would be too high. I decided to buy a house before the raise took effect, but I didn't have any cash for a down payment. Luckily, I was able to borrow 103% of the purchase price, using a special mortgage that let me put the extra 3% toward energy-saving improvements to the home. My income increased after I got the promotion, and then I got married. Now, with our combined income, we can even afford to make prepayments on the mortgage. And in the five years since I bought the house, its value has doubled." Ben was about to get a promotion. "I was excited," says Ben, "until I realized that I'd no longer qualify for the government-assisted, low-interest loan I'd been counting on-my salary would be too high. I decided to buy a house before the raise took effect, but I didn't have any cash for a down payment. Luckily, I was able to borrow 103% of the purchase price, using a special mortgage that let me put the extra 3% toward energy-saving improvements to the home. My income increased after I got the promotion, and then I got married. Now, with our combined income, we can even afford to make prepayments on the mortgage. And in the five years since I bought the house, its value has doubled."

Principal, Interest, Taxes, and Insurance

Ever heard of PITI (pronounced "pity")? It stands for principal, interest, taxes, and insurance, all of which must be factored into your homebuying plans. Here's the breakdown on these expense items: * Principal. Principal. The amount you borrow from the lender and must pay back, month by month. The amount you borrow from the lender and must pay back, month by month.* Interest. Interest. A percentage of the overall borrowed amount that the lender charges you to use its money. The exact rate varies widely. A percentage of the overall borrowed amount that the lender charges you to use its money. The exact rate varies widely.* Property taxes. Property taxes. Taxes vary by state and sometimes by local area, but expect to pay between 2% and 4% of the house purchase price each year, if the place you live fits the national average. Taxes vary by state and sometimes by local area, but expect to pay between 2% and 4% of the house purchase price each year, if the place you live fits the national average.* Homeowners' insurance. Homeowners' insurance. Coverage for theft, fire, and other damage to the property (required by your lender) and usually for your liability to people injured on your property or by you. Average rates run upwards of $600 per year. Coverage for theft, fire, and other damage to the property (required by your lender) and usually for your liability to people injured on your property or by you. Average rates run upwards of $600 per year.

It makes sense that these four items have their own acronym, PITI, because for some homebuyers (usually those whose down payment is less than 20%), all four must be paid straight to the mortgage lender each month. The lender turns around and pays the appropriate party. The lender's rationale is that if you don't pay these bills (or your mortgage) and the lender gets the property, it doesn't want to get stuck with your tax or insurance bill, too.

TIP.

PITI is paid differently when you buy a condo or co-op. Instead of paying the lender, you may have to pay your community association or co-op board for your portion of the mortgage and real estate taxes (on a co-op), or for insurance on the jointly owned parts of the property (on either a condo or a co-op). Instead of paying the lender, you may have to pay your community association or co-op board for your portion of the mortgage and real estate taxes (on a co-op), or for insurance on the jointly owned parts of the property (on either a condo or a co-op).

Added together, your total PITI may come to a lot more than your current monthly rent. That makes owning a home look like an expensive proposition. But it's not an apples-to-apples comparison. First, remember that your mortgage payments typically reduce your loan principal, so your payment is building equity, not just going into a black hole. Second, your interest payments and property taxes are tax-deductible.

EXAMPLE: Mieko and Lyle buy a house for $250,000, putting down $25,000 and financing the remainder with a mortgage. Not only are their monthly mortgage payments $1,350 a month, but the mortgage lender also collects $450 each month to pay their homeowners' insurance and annual property taxes, for a total monthly payment of $1,800. The money for the tax and insurance bills is held in an escrow account, which the lender draws on to pay the bills when due. At the end of the first year, Mieko and Lyle will be able to deduct about $15,800 from their taxable income: $2,400 for property taxes and about $13,400 for interest paid on the mortgage. Mieko and Lyle buy a house for $250,000, putting down $25,000 and financing the remainder with a mortgage. Not only are their monthly mortgage payments $1,350 a month, but the mortgage lender also collects $450 each month to pay their homeowners' insurance and annual property taxes, for a total monthly payment of $1,800. The money for the tax and insurance bills is held in an escrow account, which the lender draws on to pay the bills when due. At the end of the first year, Mieko and Lyle will be able to deduct about $15,800 from their taxable income: $2,400 for property taxes and about $13,400 for interest paid on the mortgage.

Up-Front Costs

Until now, we've been talking about costs associated with the house itself. But you'll also have to spend some pretty serious cash at the beginning to make the sale happen. (Sort of like paying first and last month's rent.) Particularly if you're trying to save up for a decent-sized down payment, you'll need to plan for the following additional up-front costs: * Closing costs. Closing costs. An array of miscellaneous and sometimes aggravating charges-for everything from couriers to loan points (discussed below) to insurance premiums-are lumped into a category called "closing costs." These vary across the country, but are usually 2% to 5% of the house purchase price. If you don't have that much, you can often finance closing costs as part of your mortgage, but of course, then you pay interest on them. An array of miscellaneous and sometimes aggravating charges-for everything from couriers to loan points (discussed below) to insurance premiums-are lumped into a category called "closing costs." These vary across the country, but are usually 2% to 5% of the house purchase price. If you don't have that much, you can often finance closing costs as part of your mortgage, but of course, then you pay interest on them.* Points. Points. Borrowers often agree to pay a "loan origination fee" or "points" to obtain a specific loan. Each point is 1% of the loan principal (so one point on a $100,000 loan is $1,000). Paying points can lower your interest rate, so you pay less in the long term. But you'll probably need to pay the cash up front (although points can be amortized into your loan-meaning added on, with interest accruing). Borrowers often agree to pay a "loan origination fee" or "points" to obtain a specific loan. Each point is 1% of the loan principal (so one point on a $100,000 loan is $1,000). Paying points can lower your interest rate, so you pay less in the long term. But you'll probably need to pay the cash up front (although points can be amortized into your loan-meaning added on, with interest accruing).* Moving costs. Moving costs. How high these will go depends on how far you're moving, how much stuff you have, and whether you use a professional moving company. How high these will go depends on how far you're moving, how much stuff you have, and whether you use a professional moving company.* Service setup costs. Service setup costs. You may have to pay fees to set up cable, phones, DSL, and similar services in your new home. You may have to pay fees to set up cable, phones, DSL, and similar services in your new home.* Emergency fund. Emergency fund. It's a good idea (and sometimes a lender requirement) to have a couple months' worth of PITI payments saved, in case something goes unexpectedly awry. It's a good idea (and sometimes a lender requirement) to have a couple months' worth of PITI payments saved, in case something goes unexpectedly awry.* Remodeling costs. Remodeling costs. If you buy a fixer-upper or a planned remodel, you might need thousands of dollars in cash early on, just to make the place livable. Estimate high for these expenses-they're almost always more than anyone expected. If you buy a fixer-upper or a planned remodel, you might need thousands of dollars in cash early on, just to make the place livable. Estimate high for these expenses-they're almost always more than anyone expected.

Recurring Costs

Yes, there's more. Whether new or old, your house will need regular maintenance-gutters cleaned and trees trimmed regularly, a paint job every few years, new appliances when the old ones die, and so on. If you buy in a common interest development, your own maintenance costs may go down, but you'll have to pay monthly dues and sometimes special assessments for unanticipated projects like resurfacing a damaged parking lot. While not part of your PITI, all of these expenses will affect your monthly cash flow.

TIP.

Adjust your deductions. Once you know the details of your mortgage, work with a financial professional to change your withholdings to account for your lower tax liability, freeing up more money for other expenses. Once you know the details of your mortgage, work with a financial professional to change your withholdings to account for your lower tax liability, freeing up more money for other expenses.

Spend Much? How Lenders Use Your Debt-to-Income Ratio

Once you understand what you'll be paying for, and that you'll probably need a mortgage to make it happen, the obvious question is, how much can you borrow? To know that, you need to understand how lenders think. Just as you're trying to get the best loan, lenders are looking for the best borrowers.

Without knowing you personally, lenders need some criteria to figure out how risky it is to lend you money. If you make your payments, they'll turn a profit, either in interest or by selling your loan on the secondary market (more on that in Chapter 6). If you don't, they'll have to chase you down for the cash or sell the property to try to get it.

One of the criteria that lenders use is the comparison between your income and your debt load, called your "debt-to-income" ratio. They also look at your track record for paying previous debts, or your credit history, discussed below.

If You Get a Loan for $250,000 ...

Assuming you're an average buyer (with about $450 per month in debt obligations) and you buy an average house (with average property taxes and insurance costs), here's about what you can expect to pay on a $250,000 loan: The concept of "debt-to-income ratio" isn't as complicated as it sounds. The lender simply looks at your household's gross monthly income, then makes sure that your combined minimum debt payments-for your PITI (including any community association fees), credit card, car, student loan, and others-don't eat up more than a certain percentage of that amount. The idea is to make sure you have enough cash left over for your mortgage payment.

Maximum Acceptable Ratios: The 28/36 Rule

How high can your debt-to-income ratio go? Traditionally, lenders have said that your PITI payment shouldn't exceed 28% of your gross monthly income, and your overall debt shouldn't exceed 36%. (Your gross monthly income means the amount you earn before taxes and other monthly withdrawals, plus income from all other sources, like royalties, alimony, or investments.) EXAMPLE: Fernando and Luz have a gross annual income of $90,000 ($7,500 per month) and a moderate amount of existing debt. If they plan to spend 28% of their gross monthly income on PITI, they'll pay $2,100 each month. Assuming they spend about $300 of that on taxes and insurance, they can borrow about $285,000 using a 30-year, fixed rate loan at 6.5% interest. Fernando and Luz have a gross annual income of $90,000 ($7,500 per month) and a moderate amount of existing debt. If they plan to spend 28% of their gross monthly income on PITI, they'll pay $2,100 each month. Assuming they spend about $300 of that on taxes and insurance, they can borrow about $285,000 using a 30-year, fixed rate loan at 6.5% interest.

Khanh and May also have an gross annual income of $90,000, but they're debt-free, so they can spend 36% of their gross monthly income on PITI. Spending the same on taxes and insurance, they can borrow about $330,000 using a 30-year, fixed rate loan at 6.5% interest. With the same income but a higher debt-to-income ratio, Khanh and May can spend a lot more money on a house than Fernando and Luz.

Calculating Your Own Debt-to-Income Ratio

All you need to figure out your own debt-to-income ratio is your combined gross monthly income figure plus that of anyone buying with you. This will tell you approximately what a lender will say you can afford to spend each month on a mortgage payment. See the sample Debt-to-Income Ratio Worksheet below.

CD-ROM.

You'll find a blank version of the "Debt-to-Income Ratio Worksheet" in the Homebuyer's Toolkit on the CD-ROM included in this book.

Debt-to-Income Ratio Worksheet

CHECK IT OUT.

Ready to run some numbers? Online affordability calculators show how a traditional lender will use your debt-to-income ratio to set your maximum monthly mortgage payment. Find such calculators at Online affordability calculators show how a traditional lender will use your debt-to-income ratio to set your maximum monthly mortgage payment. Find such calculators at www.nolo.com/calculators, www.hsh.com, and www.interest.com. Make sure any calculator you use factors in the amount of your down payment, your income and your debts, and your estimated taxes and insurance.

Blasts From the Past: How Your Credit History Factors In

Aside from your available income, your lender's main preoccupation will be with your credit history. Most lenders want to know whom they'll be competing with to get your monthly dollars, how much you're borrowing from those various sources, and how good you've been about paying money back in the past. You've probably undergone credit history checks before, like when you applied for a car loan or rented a new apartment.

Credit reporting bureaus exist to keep track of your borrowing habits. The three major companies are Equifax (www.equifax.com), Experian (www.experian.com), and TransUnion (www.transunion.com). They use a formula compiled by the Fair Isaac Corporation to calculate your "FICO" score (which we'll call your "credit score"; but beware when you see this term other places, because anyone can compile a number and call it a "credit" score).

Managing your money is so easy!

You just use your credit cards! You pay your American Express with your Discover, your Discover with your Visa, your Visa with your MasterCard. Before they catch up with you, you're buried in a glorious crypt in Bel-Air!Camilla, character on TV series The Naked Truth The Naked Truth

How Lenders Use Credit Scores

Lenders use your credit score to decide whether to lend you money and, if so, how much and on what terms. If you'll be financing your home jointly with others, the lender will look at each person's credit score. Unfortunately, that means that if one of you has a low score, it will probably affect the terms of the loan offered to all of you. If any of you has serious skeletons in the financial closet, either clear out the closet, reconsider the joint purchase, or get creative with your financing strategies.

Getting Your Own Credit Report and Score

The best way to know exactly what prospective lenders will be looking at is to look at it yourself first. Federal law requires the three major consumer reporting companies (named above) to provide you with a free copy of your credit report once every 12 months.

CHECK IT OUT.

The only authorized source for free credit reports: Go to Go to www.annualcreditreport.com. Other websites may advertise a "free report" but try to sell you something in the process. This site also links you directly to the websites for the big three reporting bureaus.

Being financially responsible left me with no credit history!

When Willow decided to buy her first house, she didn't expect her lack of debt to create a problem. Willow explains, "I'd worked my way through school and taken out a student loan that I'd paid off almost immediately. And I'd always used a debit card instead of a credit card. As a result, I had to jump through all sorts of extra hoops, providing a letter from my old landlord showing that I paid the rent on time; showing records of my payments of phone bills, cable bills; and even having my parents add my name to their credit card account. (That last strategy worked faster than I expected-within one month, my credit score was the same as theirs.) Here I thought I'd been so good at controlling my finances, yet I discovered I'd been completely naive when it came to creating a record of debt payments."

It's a good idea to ask all three agencies for your credit report. They sometimes have different information, and your lender may be looking at all three reports. You can do this simultaneously, but it means that you won't be able to get another free report from any of them for another full year.

Federal law doesn't require the agencies to give you your credit score score, which is different from your report. You'll probably have to pay extra to get the score (unless you live in a state like California that requires that consumers be given their scores for free when getting a mortgage). You can get your credit score either from the individual consumer reporting company websites or by going to www.myfico.com.

What Your Credit Score Means

When you get your credit score, it will be a number somewhere between 300 and 850-the higher the better. If your score is in the 700s, it's considered pretty strong. Most people are in the 600s or 700s. A higher number tells the lender you pay your debts on time, have limited sources of revolving credit, and have an established record of using credit prudently, making you a good credit risk. A lower number means you look more risky-perhaps because you have enough revolving credit that if you maxed it all out you couldn't pay all your bills plus a mortgage; you've missed payments in the past; or you've never used any credit source, so the lender doesn't know what to make of you.

A low score doesn't always mean no one will lend you money. But the lender will expect you to pay more for that privilege, probably in the form of higher interest. (If your credit is less than perfect, you can clean it up, as we'll discuss below.) CHECK IT OUT.

What makes up a FICO score? It includes your payment history (35% of the score), how much you currently owe (30%), how long you've been a borrower (15%), whether you have any new credit accounts (10%), and the types of credit you use (10%). To learn more, go to It includes your payment history (35% of the score), how much you currently owe (30%), how long you've been a borrower (15%), whether you have any new credit accounts (10%), and the types of credit you use (10%). To learn more, go to www.myfico.com, a Fair Isaac website for consumers.