Can You Take Out a Loan for a Down Payment on a House?

Buying a house is an exciting milestone in life. However saving up enough money for a down payment can be challenging especially for first-time homebuyers. You may be tempted to take out a loan to cover the down payment. But is this a good idea? Let’s explore the pros and cons.

What Loans Can Be Used for a Down Payment?

There are several types of loans you could potentially use for a house down payment:

• Home Equity Loan or HELOC You can tap into your home’s equity if you currently own. This converts your equity into cash to put toward the new home’s down payment

• Personal Loans: Unsecured loans from a bank, credit union or online lender. Amounts usually range from $1,000 – $50,000.

• 401(k) Loan: You can borrow against your 401(k) account up to 50% of the balance or $50,000, whichever is less. This must be repaid over 5 years.

• Family/Friend Loans: Borrowing from someone you know. Often more flexible terms than bank loans.

• Bridge Loans: Short-term loans using equity from the home you are selling. Allows you to buy before selling.

• Down Payment Assistance: Government and non-profit programs offering grants, loans and other help. Eligibility requirements vary.

The Downsides of Down Payment Loans

Using a loan for the down payment may seem convenient. But there are some significant risks and drawbacks to be aware of:

• Higher Interest Rates: Loans like personal loans or credit cards usually have much higher interest rates than mortgage rates. This results in more expensive payments.

• Shorter Repayment Term: Personal loans may need to be repaid in 2-7 years. This leads to high monthly payments on top of the new mortgage payment.

• Mortgage Denial: Lenders usually won’t approve a mortgage if you need to borrow the down payment. It raises questions about your financial readiness.

• Higher Debt-to-Income Ratio: Additional monthly loan payments increase your DTI, which could disqualify you from getting a mortgage.

• 401(k) Withdrawal Penalties: You’ll pay income tax and a 10% early withdrawal penalty if you default on a 401(k) loan.

• Lower Credit Score: Too many credit applications in a short period can cause your score to drop. Lenders want to see your best possible credit score.

• Relationship Strain: Borrowing from family/friends adds stress to the relationship if you can’t repay on time.

When Can You Use a Loan for the Down Payment?

While lenders generally frown upon down payment loans, there are a few cases where you may be able to make it work:

• If you have excellent credit (760+ score) and low debt-to-income ratio, some lenders may approve you using a 0% APR credit card or personal loan for a small portion of the down payment.

• 401(k) loans are more commonly allowed than personal loans, but still risky if you lose your job. Make sure you have a stable work situation first.

• If a family member genuinely wants to gift you money with no expectation of repayment, some lenders will allow this with proper documentation.

• Down payment assistance programs are specifically designed to help with down payments. If you qualify based on income limits, these can be a great resource.

• Bridge loans utilize your current home’s equity, so lenders view this option more favorably than an outside personal loan.

Tips for Saving for a Down Payment Without Loans

Since down payment loans are generally inadvisable, you’ll want to save up in safer ways. Here are some tips:

• Start saving early, as soon as you can. Consistently setting aside money is key, even if it’s a small amount at first.

• Create a reasonable budget that frees up as much cash as possible for savings each month. Cut discretionary spending where you can.

• Boost your income with a side gig, promotion, or new higher-paying job. Use this extra money only for the down payment savings.

• Open a high-yield savings account to earn more interest on the money you’re saving. Look for accounts with 2% APY or higher.

• Reduce debts, especially higher interest debts like credit cards, so you can shift more cash towards home savings.

• Contribute to a 401(k) up to your employer’s match limit before prioritizing down payment savings. Don’t miss out on this free money.

• Save your tax refund, bonuses, graduation gifts, or any financial windfalls. Put them directly into your down payment fund.

• If you’re moving up to a higher priced home, use equity from selling your starter home to boost your savings.

Alternatives If You Can’t Save Enough

If you’re having trouble saving up the traditional 20% down payment, don’t lose hope. Here are some alternative options to get into homeownership sooner:

• Low down payment mortgage programs like FHA (3.5% down) or conventional 97 (3% down) allow down payments under 5%. You’ll pay mortgage insurance until 20% equity is reached.

• VA loans and USDA loans offer 0% down options for qualifying military families and rural home buyers.

• Down payment assistance programs provide grants or second mortgages to cover all or part of the down payment. Income limits apply.

• Ask sellers if they’d consider seller financing, where they act as the mortgage lender and collect payments from you.

• See if family members might gift you money for the down payment. This requires documentation stating it’s a non-repayable gift.

• If buying a fixer-upper property, ask for the seller to pay closing costs to make up for the renovation costs ahead.

The Bottom Line

While it’s tempting to look into down payment loans, this move comes with considerable risks that can jeopardize your home purchase. Whenever possible, strive to save up a down payment through your own budgeting, savings, and wise financial habits over time. But if your savings come up short, viable alternatives like low down payment mortgage programs exist to help you achieve your dream of homeownership.