Coming up with enough cash for a down payment to buy a house is often the biggest hurdle for prospective homebuyers. To avoid paying for mortgage insurance, you typically need to put down 20% of the purchase price. These days that can be a hefty sum: The average home sales price in the second quarter of 2024 was around $500,000, which means a typical buyer will need to accumulate at least $50,000 to purchase a home.
If you don’t have that kind of cash sitting around, using a personal loan might sound like a great solution. Unfortunately, many mortgage lenders do not permit you to do this. Even if you can find one who does, it may not be a good idea. Here’s what you need to know about using a personal loan for a down payment.
Why Can’t I Use a Personal Loan as a Down Payment?
As part of the mortgage application process, a lender will want to verify the sources for your down payment. Being able to provide documentation that you have enough money in savings to cover your down payment (and then some) gives the lender confidence in your strength as a borrower and your ability to repay the loan.
If you fund a down payment through a personal loan, however, a lender may see it as a sign of potential financial instability, which raises their risk. As a result, some types of mortgages — including conventional mortgages and FHA mortgages — forbid the use of personal loans as a down payment for a home.
Why Is It Bad to Use a Personal Loan for a Down Payment on a House?
Even if you are able to find a mortgage lender who allows you to use a personal loan for a down payment, doing so can have several negative consequences. Here are the primary reasons why it’s considered a bad idea.
• It can increase your DTI: Having a personal loan on your credit reports impacts your debt-to-income (DTI) ratio — how much of your monthly income goes to repaying debts. A higher DTI ratio can make it more challenging to qualify for a mortgage or reduce the amount for which you can qualify.
• It might increase your interest rate. Taking out a personal loan to cover a down payment signals to a mortgage lender that you’re financially stretched and may not be able to afford homeownership. This makes you a greater risk. To protect themselves, a lender may offer you a higher rate than a borrower using savings for their down payment.
• Higher monthly payments: Personal loans typically have shorter terms and higher interest rates than mortgages. Using a personal loan for a down payment means additional debt on top of a mortgage, which could be difficult to manage and lead to financial strain.
• Greater risk of default. If your budget is stretched due to multiple debts, you could potentially fall behind on your personal loan, mortgage payments, or both. If that happens, you risk defaulting on your debt, damaging your credit, and in a worst-case scenario, losing your home.
Recommended: Typical Personal Loan Requirements Needed for Approval
What Are Alternatives to a Personal Loan for a Down Payment?
Instead of using money from a personal loan for a down payment on a house, here are other ways to fund this milestone purchase.
Savings
If you’re not in a rush, you may want to push back your home purchase and ramp up your savings. To ensure consistency with your savings, consider setting up an automated transfer from checking to a dedicated savings account for a set day each month. You might also want to put any windfalls — like a tax refund, work bonus, or cash gift — toward your down payment fund to get to your goal faster.
Recommended: How to Afford a Down Payment on Your First Home
Gifts From Family
Many mortgage lenders allow down payment funds to come from gifts provided by family members. If you have relatives who are willing and able to assist, this can be a viable option. Since a lender may ask you to substantiate any large deposits into your bank account, it’s a good idea to ask the giver to provide a letter to your lender detailing the amount and confirming that it is a gift and not a loan.
Down Payment Assistance Programs
Various local, state, and federal programs offer down payment assistance to eligible homebuyers. These programs can provide grants, low-interest loans, or forgivable loans to help cover your down payment and closing costs. They’re typically geared toward first-time homeowners who are low- to middle-income. The Department of Housing and Urban Development (HUD) allows you to search local home-buying programs by state on the HUD website.
Look Into Loans That Require a Smaller Down Payment
There are some types of mortgages that do not require a large down payment. FHA loans (which are insured by the Federal Housing Administration), for example, allow eligible borrowers to put down as little as 3.5%. USDA loans (targeted to certain suburban and rural homebuyers) and VA loans (designed for U.S. service members and their surviving spouses) don’t require any down payment.
Recommended; Guide to Getting a No Down Payment Mortgage
Retirement Account Loans or Withdrawals
Some retirement accounts, like a 401(k) or IRA, allow you to take out a loan or make a withdrawal for a home purchase. While this option can provide the necessary funds, it’s essential to understand the implications, such as potential taxes, penalties, and the impact on your retirement savings. It’s a good idea to consult with a financial advisor to determine if this could be a good option for your situation.
Recommended: Guide to Personal Loans for Beginners
The Takeaway
Taking out a personal loan might seem like a good way to get the funds for a down payment on a home. The problem is that many mortgage lenders won’t permit you to use a personal loan for down payment and, if they do, may charge you a higher interest rate or lower your loan amount, as they will view you as a risky borrower.
Personal loans are generally better left for other purposes, such as covering emergency expenses, consolidating credit card debt, or making home repairs or improvements (once you become a homeowner). If you are considering getting a personal loan, be sure to shop around to find the right offer. Personal loans from SoFi, for instance, offer competitive fixed interest rates.
FAQ
Can you use a personal loan for closing costs?
It may be possible to use a personal loan to cover closing costs when buying a home. These costs, which may include appraisal fees, title insurance, and attorney fees, can add up quickly. Just keep in mind that some mortgage lenders may not approve a borrower for a mortgage if they have recently taken out a personal loan, as it shows you may not be in a strong financial position to take on other new debt.
Do banks check what you spend your loan on?
Banks typically do not check or monitor what you spend the funds from a personal loan on. Once the loan is approved and the funds are transferred to your bank account, it is up to you to use the money as agreed upon in the loan agreement.
Keep in mind, however, that misusing the funds from a personal loan can have financial and legal consequences. If you use the loan money for something other than what was outlined in the loan agreement, you are technically in violation of the terms of the loan. This could potentially lead to penalties, legal action, or damage to your credit score.
What happens if you don’t use all of your personal loan?
If you don’t use all of your personal loan, you’re still responsible for repaying the full amount borrowed, along with interest. If your lender doesn’t charge a prepayment penalty, you might consider using the excess funds to pay off your loan ahead of schedule — this can reduce the total amount of interest you’ll pay for the loan.
Photo credit: iStock/whitebalance.oatt
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