Your Down Payment: Where Will It Come From?

Lack of a down payment discourages many would-be home buyers.

Most home buyers don't have large cash reserves, and therefore hope to make as low a down payment as possible. Unfortunately, lenders are cautious, especially after a history of dramatic industry downturns. They'll want to see both a 20% down payment and a high credit score before lending money to a homebuyer at all, much less lending on the most advantageous terms. Low down payment loans aren't impossible to find, but are tough to qualify for, and come with high interest rates.

In any case, there are advantages to putting down 20%. You lower your monthly mortgage payments, and you avoid paying for private mortgage insurance (PMI).

If you haven't already saved up thousands of dollars, here are some ways to pull together the needed funds.

Accessing Your 401(k) Plan

Check with your employer or its 401(k) plan administrator to see whether the plan allows you to draw on your 401(k), often referred to as a sort of loan.

If so, the maximum amount you can legally remove is likely to be the lesser of one-half of your vested balance in the plan or $50,000 (unless you have less than $20,000 in the account, in which case you can borrow the amount of your vested balance, but no more than $10,000). Special provisions allow higher amounts for people affected by the COVID-19 pandemic.

Other conditions, like maximum term, minimum loan amount, interest rate, and applicable loan fees, are set by your employer. The Tax Code says you must repay the loan, with interest, within a "reasonable amount of time."

Find out what happens if you leave the company before fully repaying this loan. If it would become due immediately upon your departure, you might have to pay income tax and penalties on the outstanding balance. But you might be able to avoid this by repaying the loan before you leave.

Tapping Into Your IRA

If you're buying your first home (meaning you've had no ownership interest in a primary residence for the two-year period ending on the date you buy the place), you can withdraw up to $10,000 from an individual retirement account (IRA) for a down payment. (You'll avoid the penalties that most others will have to pay.) Your spouse, if you're buying together, can do the same.

However, you might have to pay income tax on the withdrawal. Also, this $10,000 is a lifetime limit, which must be used within 120 days of receiving it. Ask your tax accountant for details, or contact the IRS.

Using a Gift to Help With the Down Payment

Family, especially parents and grandparents, will often help with home purchases. As a practical matter, the gift must come from a close family member. The lender involved in the rest of the deal won't trust that gifts from distant family members or friends are not secret loans. In fact, the lender can refuse to approve a loan where the entire down payment will come from a gift.

Gifts up to an annual exclusion ($15,000 per person per year for tax year 2020) can be given without worrying about filing a gift tax return. This means, for example, that every year your mother and father can give you and your spouse a total of $60,000 without having to file a gift tax return. They should also give you a letter stating that the money is indeed a gift with no expectation of repayment.

Borrowing Down Payment Money From a Relative or Friend

Another way to raise money for a down payment is to borrow it from friends and family. Many people prefer to ask their loved ones for a loan rather than an outright gift. Of course, you must repay the money someday, and your bank or institutional lender will factor this addition to your debt burden into its own decision on whether to loan you money. For more information, see Borrowing From Family and Friends to Buy a House.

Sharing Space

Buying a house together with someone who isn't a spouse or partner is a growing trend. No wonder, since it can cut your costs in half and help you break into the real estate market. For details on how this can work, see Cobuying a Home.

Sharing Equity

Another way to enlist the help of family or friends, or even an investor, is to give up a share of the ownership of your house in exchange for a cash contribution. Assuming that this person doesn't actually share your house, however, such arrangements can give rise to conflicts. With one of you viewing the house as a home and the other viewing it as an investment, issues such as the need for remodeling, or the other person's desire to sell the house, could be hard to resolve.

Using Equity in an Existing House

Trading up is an integral part of the homeownership dream. You buy a starter house, wait for it to go up in value, sell it, and use the profit as most or all of the down payment on a nicer house.

Of course, this works only in a rising real estate market. Historically, real estate prices in the U.S. have moved continually upwards even after serious dips, but you'll need to figure out how long you're likely to wait in the same home for values to move upward significantly.

Once values start to rise, trading up to raise down payment money works better than saving money or making other investments. That's because purchasing a house is a highly leveraged transaction, meaning the amount you invest is only a small part of the amount you borrow. In any leveraged transaction, you see big gains not only on your money, but also on money you've borrowed.

For example, if you put $20,000 down on a $200,000 house (borrowing $180,000) and the house appreciates to $300,000 while you're living there, you've made $100,000 with a $20,000 investment. By contrast, if you deposited the same $20,000 in an unleveraged investment, such as stock or art, and it goes up the same 50%, you'd end up with $30,000.

For more information on raising a down payment and financing your house purchase, see Nolo's Essential Guide to Buying Your First Home, by Ilona Bray, Ann O'Connell, and Marcia Stewart. Also see IRAs, 401(k)s & Other Retirement Plans; Strategies for Taking Your Money Out, by John Suttle, CPA and Twila Slesnick, PhD (Nolo).

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