Once you’ve decided that buying a home is right for you — you have a steady income, you want to stay in the area for at least a few years, and your debt load is low — you now need to consider how you’ll finance this purchase.
Besides figuring out if you can make the monthly mortgage payments, you need to have some cash to put down for a down payment and closing costs. What if you don’t have enough? A down payment needs to be 20% of the purchase price of the home to avoid paying private mortgage insurance. And closing costs could run you between 2% and 5% of the purchase price. Besides that, you need a good credit score of at least 650 to get a conventional mortgage. What if you don’t?
Here are some creative financing ideas to get you into your first home, even if you’re not the traditionally perfect candidate.
1. Seller Financing
In a seller-financing deal, you don’t work with a lender at all — the seller is the lender. You would make your mortgage payments directly to the seller. These deals might be few and far between, but they do exist. You just need to find one. You should expect to either pay a high interest rate or a hefty down payment to get the seller on board with the deal. Owners who are having a difficult time selling their home are the ones most likely to offer a seller financing deal. A typical scenario is that of an older homeowner who has the house paid off but can’t afford to make needed repairs. They can’t sell the house in its present condition, so they offer seller financing to make the deal available to a different market (buyers who don’t qualify for a traditional loan). Buyers typically need to sign a promissory note, which lists the repayment schedule, the interest rate, and what the default consequences are. Seller financing arrangements generally won’t last for 30 years, as a typical home loan with a mortgage lender does. The deal is usually set up to be amortized for 30 years (your payments are based on paying off the loan in 30 years), but with a balloon payment after five years. The theory is that in five years, you will qualify for a conventional loan, at which time you would refinance, pay off the seller, and then have a mortgage with a bank or mortgage company. The catch? If you can’t refinance when the balloon payment is due, you lose the house.
2. Rent to Own
A rent-to-own deal allows you to live in the house as a tenant but with the option to buy. A typical rent-to-own deal has you renting the house for one to three years while you’re working on improving your credit score and saving for a down payment. After that set period is up, you can buy the house. The catch? Having an option to buy comes at a price. Potential buyers usually need to pay the owner a one-time fee called “option money,” or words to that effect. This fee varies depending on the deal you strike. Option fees generally fall somewhere between 2.5% and 7% of the purchase price. In some deals, some or all of the option money goes toward buying the house. In other deals, it doesn’t. Bonus tip: Part of the rent you pay in a rent-to-own deal could be applied to the house purchase. So, for example, if your rent were $1,500 a month with 25% of that going toward the purchase price, $375 a month would be credited to your purchase. (Note that the rent you pay might be slightly more than rents in your area if some of it will be credited back to you when you buy.) If your deal were to rent for two years, you would have a credit of $9,000 going toward the purchase. Another catch: If you decide not to buy the house after the rent period is up, you lose your option money and the purchase credit.
3. Tap Your Retirement Account
You can borrow up to $10,000 from your IRA to buy your first home. If you’re married, you and your spouse can both borrow this amount, for a total of $20,000. What’s significant about this is that you normally can’t withdraw money from your IRA until you’re 59 1/2 without facing a 10% penalty fee and owing taxes due on the money you withdraw. You can also borrow from your 401(k). You’re allowed to borrow 50% of your 401(k) up to $50,000. The catch? You better be ready to buy when you borrow from your IRA. The clock starts ticking once you withdraw the money. You then have 120 days to buy a home. Otherwise you’re subject to that penalty charge and any tax that’s due. And regarding your 401(k), you need to pay back what you borrow within five years. If not, you owe a 10% penalty. Also, if you leave or lose your job, the loan becomes due in 60 days to avoid the penalty.
4. Borrow Money
If you have a friend or family member who’s in a position to lend you the money to buy a home, this might be a good option for you. Called a private mortgage, this type of loan works the same way as a loan from a bank or credit union would. You sign a contract that spells out the terms of the loan, such as the payment schedule and the interest rate. If you default on the loan, your friend or family member can, at that time, call in the loan. In that case, you’d need to get financing from a bank or credit union to pay off your private lender. If you can’t get one, your private lender can foreclose. The catch? Awkward! And you might have lost not only your home, but also an important relationship.
5. Crowdfund
Crowdfunding is a public way to raise money for anything. So, many people who are planning a wedding but who don’t really want blenders or to pick out a china pattern, but who do want cash that they can apply for a down payment on a home, start a crowdfunding account. There are mainstream crowdfunding sites, such as GoFundMe or Kickstarter. But there are also sites set up specifically for this purpose, such as Hatch My House and Feather The Nest.
6. FHA Loan
The Federal Housing Administration (FHA), a government agency that works under the U.S. Department of Housing and Urban Development (HUD), backs loans to borrowers who don’t qualify for a convention loan from a bank, credit union, or mortgage lender. You would still go through a traditional lender, but you would ask for an FHA loan, which many lenders offer. You need a credit score of only 580 to qualify for an FHA loan, and your down payment can be a little as 3.5%. In some cases, you can get an FHA loan with a credit score of as low as 500 if you put down 10% for the down payment. The catch? You pay an upfront insurance premium of 1.75% of the loan. This cost is added to your mortgage. In addition, you must pay an annual mortgage insurance premium of 0.85% of your loan balance for as long as you have the loan. This differs from the private mortgage insurance you pay on a conventional loan in that you get to stop paying PMI as soon as you have 80% equity in the home. Bonus tip: The solution to avoid the annual mortgage insurance premium would be to refinance your FHA loan to a conventional loan once you get your credit score up to an acceptable level. Even if you aren’t a traditional candidate for obtaining a mortgage, as you can see, there are still many options available to you. If it’s your time to buy a house, you can make it work.