Can You Use a Personal Loan for a Down Payment on a Home?
Personal loans have become popular in recent years, particularly with the advent of peer-to-peer (P2P) lending platforms.
Depending on the lender, you can borrow as much as $100,000 – and sometimes more – on an unsecured loan, for just about any purpose.
That includes using a personal loan for the down payment on a home.
Personal loan lenders put very few restrictions on the use of funds from those loans.
However, the problem comes in with the other loan in the homebuying process, and that’s the mortgage. While it is possible to borrow money for the down payment on a home, the mortgage industry puts restrictions on the type of loans you can use.
As a general rule:
Mortgage lenders will allow the use of proceeds from a secured loan as a down payment source. However, since most personal loans are unsecured, they’ll be disqualified from eligibility.
But even if you could use a personal loan for a down payment on a home, there are abundant reasons why you wouldn’t want to.
Can You Use a Personal Loan for a Down Payment on a Home?
Yes, as far as personal loan lenders are concerned, you can use the loan proceeds for any purpose, including a down payment on a home.
The obstacle will be the mortgage lender, who won’t allow the use of unsecured funds for a down payment.
However, there is something of a workaround.
Mortgage lenders will typically verify both new loans and large deposits into your bank accounts within 60 to 90 days of applying for a mortgage.
If there are any new loans or large deposits, they will very likely require you to explain the source of the deposits, as well as to certify that any funds used for the down payment on the proposed home are not borrowed.
What the mortgage lender is trying to avoid is a situation in which 100% of the purchase price of a home is financed.
Most mortgage loan programs don’t permit such arrangements. That’s because mortgages in which the borrower makes a down payment have a lower default rate than those with no down payment.
The workaround:
If you were to take a personal loan and deposit the funds into a bank account several months before applying for a mortgage, the lender may not ask for additional documentation.
The funds can then be used for both the down payment and to cover closing costs and tax and insurance escrows.
But even this strategy isn’t necessarily recommended.
Why Using a Personal Loan for a Down Payment on a Home is a Bad Idea
Even if you succeed in taking a personal loan and deposit the funds months before applying for a mortgage, there will be problems that can have a negative effect on the mortgage application process.
The biggest is your ability to qualify for the mortgage.
One of the qualifications mortgage lenders look at is your debt-to-income ratio, commonly referred to as the “DTI”. That’s your new house payment, plus recurring obligations, divided by your stable monthly income.
Recurring obligations include monthly payments for:
- child support or alimony
- credit cards
- car loans
- payments on other real estate owned
- other installment loans
If your stable monthly income is $5,000, the new house payment will be $1,200, and you have $800 in recurring non-housing obligations, your DTI is 40% ($2,000 divided by $5,000).
The maximum allowable DTI is 50% for mortgage lenders.
If you exceed 50%, your loan may be declined.
The monthly payment on the personal loan
The problem with a personal loan, particularly a large one, is that the monthly payment may cause problems with your DTI.
For example, let’s say you’re looking to purchase a $200,000 home with a 20% down payment. That comes to $40,000. If you take a $40,000 personal loan with a term of five years at an interest rate of 10%, your monthly payment will be $719.
There’s an excellent chance a payment that high will either hurt your chance of being approved for a mortgage on the property you want to buy.
Or, it will force you to buy one that’s much less expensive.
The impact of the personal loan on your credit score
If you take a large personal loan and deposit the proceeds in a bank account several months before applying for a mortgage, it’s almost certain your credit score will drop.
It may even fall substantially.
That’s because new loans raise your credit risk.
After all, with just a few months of payments made, the credit bureaus can’t properly assess your long-term ability to manage the new debt.
And in addition to the short payment history, there’s also the credit utilization issue.
If you owe $39,000 on a loan with an original balance of $40,000, the credit bureaus will recognize that as your being potentially overextended. Your credit score can be further impaired by that calculation.
Collectively, your credit score may drop 20, 30, or even 40 points.
The reality is:
A drop like that can hurt your mortgage application, either by:
- making you ineligible for the mortgage amount you want, or
- making you pay a higher interest rate.
This requires a bit of an explanation.
Mortgage loans use what’s known as tiered pricing. That is, your loan rate is determined by several factors.
For example, your rate will be lower with a larger down payment, and higher with a smaller down payment. The same is true with credit scores. The lower your credit score, the higher the interest rate you’ll be charged.
When you add that higher mortgage payment to the monthly payment on a personal loan, you may find yourself suddenly unable to purchase your dream home – or even any home at all.
Mortgage lender may “connect the dots”
The possibility is very real that the mortgage lender will connect your bank balance with your recent personal loan, even if more than 60 days pass before you make an application for a mortgage.
Let’s say you need $40,000 for the down payment on the house you want to buy. You have a current bank balance of $41,117. But your credit report shows you took a $40,000 personal loan six months ago.
The mortgage lender may see that connection, and require you to provide proof that the personal loan isn’t the source of the funds sitting in your bank account.
If you’re unable to prove that, your mortgage application may be declined.
How to Build Up a Proper Down Payment
For most mortgages, you’ll be required to make a minimum down payment equal to between 3% and 5% of the purchase price of the property.
For a $200,000 home, a 3% down payment will require $6,000. At 5%, the requirement will be $10,000.
The best, cleanest way to make that down payment is to save up the money over a year or more before applying for a mortgage.
But even if you can’t save that much, or can’t save it all, there are options.
If you’re a veteran, you can apply for a VA mortgage. These loans provide 100% financing, eliminating the need for a down payment.
If you’re not a veteran, you can make the down payment using other methods.
Traditional and Roth IRAs
One is to withdraw funds from an IRA. Under IRS rules, you can withdraw up to $10,000 from a traditional IRA without having to pay an early withdrawal penalty. (However, you will have to pay ordinary income tax on the amount withdrawn.)
If you have a Roth IRA, you can withdraw the amount of your contributions to the plan, without paying either taxes or an early withdrawal penalty. (However, both ordinary income tax and the early withdrawal penalty will apply to any investment income portion withdrawn.)
Gift from a family member
If you do get a gift, you’ll be required to provide the following documentation:
- A fully executed gift letter, signed by the donor, indicating the gift amount, the source of the gift, the relationship the donor has to you, and that the gift is, in fact, a gift, and not a loan that will require repayment.
- The donor may be required to furnish evidence he or she has the funds available to provide the gift.
- Evidence of the transfer of funds before closing.
Down payment assistance programs
Many states, counties and large cities periodically provide down payment assistance programs to local home buyers.
In most cases, you will need to meet requirements as a low-income borrower. However, rules vary from one program to the next.
Down payment assistance may be set up as either a public gift or as a loan. When it is set up as a loan, the debt is typically forgiven after you’ve made on-time payments for several years.
The loans will serve as the down payment, usually in connection with FHA mortgages. FHA mortgages require borrowers to make a down payment equal to 3.5% of the purchase price of a home. FHA approved down payment assistance programs will be allowed to provide down payment funds.
Alternative Loans for Borrowers without Enough Down Payment
Mortgage lenders don’t permit down payment funds to come from unsecured loans, like personal loans and credit lines. But they do permit loans from secured sources.
For example, if you already own one property, you can take a loan secured by that property, and use it to make the down payment on a new home.
Another common source is retirement plan loans.
Employer-sponsored plans, like 401(k) and 403(b) plans, allow you to borrow 50% of your vested interest in the plan, up to $50,000. Since the proceeds are secured by your retirement plan, they’ll be permitted by the mortgage lender.
Still another possibility is to get secondary financing on the home you’re purchasing.
Let’s say you plan to take an 80% mortgage on your new home. If you qualify based on income, the first mortgage lender may allow you to take a second mortgage for an additional 10% or 15% of the purchase price. That won’t eliminate your down payment completely, but it will lower it substantially.
Conclusion
Personal loans are not a recommended source of funds for the down payment on a home.
Even if they were permitted by mortgage lenders, the monthly payment, in combination with the decline in your credit score, may hurt your chance of being approved on the mortgage.
Instead, try one of the alternatives.
