The 20% Down Payment Was Supposed to Be Dead. Is It Making a Comeback?

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If you’re hoping to buy a home this year with a small down payment, prepare for a reality check.

One of the far-reaching consequences of the pandemic is that the 20% down payment is making a comeback.

Just to be clear: Lenders aren’t requiring you to put 20% down. Mortgages backed by the Federal Housing Administration, known as FHA loans, require just 3.5% down with a minimum 580 credit score. Veterans can still get a VA loan with no money down. Conventional loans, which aren’t backed by the government and have stricter credit requirements, still allow down payments as low as 3%.

Yet here’s what a typical down payment looked like in 2021:

  • 25% of residential sales were cash deals in April 2021, according to the National Association of Realtors.
  • Of the remaining three quarters of buyers who did finance a home, 50% made a down payment of at least 20%, the National Association of Realtors reports.
  • Just 29% of first-time homebuyers made a 20% down payment in April 2021. But first-time buyers are increasingly squeezed out of the market. The percentage of buyers who were purchasing a first home fell from 36% in April 2020 to 31% a year later.
  • The median down payment for September 2020 through February 2021 was 15.9%, according to Redfin data. That’s up from 15.3% for September 2019 through February 2020.

If the difference between a 15.9% down payment vs. a 15.3% down payment doesn’t sound like much, consider that the median sales price shot up by nearly 14% during the same period. For the homebuyer, those numbers translated to a down payment that’s more than $8,500 higher compared to one year earlier.

Why Down Payments Are Getting Bigger

Even before COVID-19, new home construction wasn’t keeping pace with population growth.

But the pandemic unleashed a flood of would-be buyers, many with the ability to work remotely for the first time, in suburban areas. Historically low interest rates have fueled demand. Wealthier buyers have sought second and third homes in record numbers.

But owners are often hesitant to put their homes on the market during uncertain times. Between March 2020 and March 2021, housing inventory shrunk by 30%, according to the Joint Center for Housing Studies of Harvard University’s State of the Nation’s Housing 2021 report.

With supply and demand so out of whack, sellers are getting an average of five offers when they sell their homes. About 50% are going for over list price. Successful buyers are also sweetening the deal for sellers by throwing in extras, like paying for the seller’s closing costs or even their moving expenses.

But banks typically won’t allow you to finance a home for more than the appraised value minus your down payment. In a red hot market, appraised values are often lower than the list price. When this happens, buyers often have no other choice but to front the additional cash.

For example, suppose you’ve agreed to pay $300,000, but the appraiser concludes the home is only worth $250,000. You’d have to come up with $50,000 cash to cover the difference because your lender will only finance $250,000.

“It’s pretty much standard now to include appraisal addendums with offers, which puts in writing that the buyer will cover any and all costs regarding low appraisals,” said Tiffany Alexy, broker/owner of Alexy Realty Group, in Raleigh, North Carolina. “With houses going so far over list now, it’s the only way to make your offer stand out.”

But the potential for a wide appraisal gap isn’t the only reason sellers care about the size of the down payment. Though contracts vary by state, in many states the seller sees how much the buyer is putting down and how much they’re financing. Sellers want to know that a deal will close quickly.

“The worst-case scenario for a seller is to accept an offer, have the buyers’ financing fall apart, then the house ends up back on the market,” said Sean O’Dowd, CEO of Chicago-based Close Concierge, which provides transaction coordination services for agents. “Many people will then assume, since the house is back on the market, that something is wrong with it. It makes it substantially more difficult to sell again.”

A low down payment doesn’t necessarily mean a buyer has shaky finances. In many cases, the buyer is simply taking advantage of low interest rates or looking to conserve cash. But it’s the perception that matters.

It’s also hard for buyers with any sort of financing to compete with cash buyers in terms of speed. A cash deal can close in a few days vs. several weeks for a financed deal.

“In the Denver metro area, we are seeing dozens of offers being made on nearly every listing within 48 hours of hitting the market,” said Sean Simon, mortgage loan originator with Planet Home Lending. “Financed buyers are having to offer appraisal gap guarantees, inspection waivers, and faster closing times. Usually we would close loans in about 30 days, and today we’ve begun offering 15 and 20 day closings to help financed buyers compete with cash.”

What About FHA and VA Loans?

Sellers tend to be especially wary of government-backed financing, like FHA and VA loans, because they think they’re inflexible and take longer to close.

In part, that’s because with government-backed loans, so much is at stake with the home appraisal.

“The Amendatory Clause of FHA states that if the house does not appraise, the buyer can back out and receive their earnest deposit back,” said David Rider, a certified mortgage adviser and retirement specialist with NEXA Mortgage in Chandler, Arizona. “In this market, where houses are selling for way over appraised price, it puts the seller in a difficult position to accept a VA, FHA or USDA loan if they want to maximize their sales price.”

Lenders often have strict appraisal requirements for government-backed loans. “Small repairs will be scrutinized by the lender,” said Peter Winscott, a Denver-based real estate agent with Orchard. “A buyer would need to ask the seller to fix these issues in order for the loan to go through, which puts FHA/VA loan buyers at a disadvantage.”

What if You Can’t Afford a 20% Down Payment?

Winscott said it’s possible for buyers without extra cash to compete if they can uncover other seller motivations. “As an example, sellers typically want extra time to move out and in many cases, still need to find their next home,” he said. “So offering an extended seller rent-back may ultimately be more important than top dollar to a seller.”

In some cases, buyers are even offering a month or two of free occupancy to the seller.

Writing a heartfelt letter to the seller has also proved to be a winning strategy for some buyers. But it’s a controversial one. In fact, the National Association of Realtors advises agents not to help clients draft or deliver “love letters” and to avoid reading them because the details they reveal often raise fair housing concerns.

You may also be able to make your offer appealing by speeding up the process. For example, you could bring a home inspector out right away, rather than waiting a week.

Waiving contingencies, which allow you to back out of a deal, may make your offer more appealing. But you should only do so with extreme caution. For example, when you waive the financing contingency, you’re forfeiting your deposit if the deal falls through because you can’t finance the purchase. You should only waive the appraisal contingency if you’re confident you can afford to make up any difference between your offer and the appraised value.

But bear in mind that home prices are rising at their fastest pace since December 2005, according to the S&P CoreLogic Case-Shiller Home Price Index. Many housing experts believe the housing market will start to cool off as life returns to normal. Many workers still don’t know whether they’ll be able to work from home permanently. A lot of empty-nesters who are ready to downsize or move to senior communities have put off selling. Inventory is likely to gradually increase as uncertainty fades.

Yale economist and Case-Shiller index co-creator Robert Shiller recently told Yahoo! Finance he expects housing prices to “come back down, not overnight, but enough to cause some pain.”

If you’re lacking cash reserves, it may be worth waiting to buy — both to save more money and to see how the housing market shakes out. That may be frustrating to hear, especially if you’ve already been waiting for some time.

But the right time to buy a home depends just as much on your personal circumstances as it does on the housing market. A good rule of thumb is that your mortgage payment shouldn’t be more than 28% of your pre-tax income. Having a three- to six-month emergency fund in addition to a down payment is essential.

The bottom line: Don’t let fear of missing out drive you to buy a home you can’t afford. And if you’re preparing to buy a home right now, be prepared to adjust your budget upward or buy less house.

Robin Hartill is a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected].