Understanding Down Payments: Mortgage Basics Explained

With property prices on the rise, it is becoming increasingly difficult for first-time buyers to get onto the property ladder. In such cases, parents often step in to help their children with the down payment for a mortgage. There are several ways parents can help, including gifting money, co-signing a joint mortgage, or acting as a guarantor. However, it is important to be aware of the potential pitfalls and seek advice from a property expert or loan officer before making any decisions.

Joint mortgages with parents

With property prices ever-increasing, getting onto the property ladder can be challenging, especially for young professionals in cities. First-time buyers are increasingly considering parental support to purchase their first home. Several lenders now offer joint mortgages with parents, either as co-applicants or guarantors. This type of mortgage is becoming more popular as it can help first-time buyers or young buyers without a substantial credit history to secure mortgage approval.

If you apply for a joint mortgage with your parents, you could buy a higher-value property if they have the income to boost your affordability. Many applicants have been living at home with their parents and do not have much credit history. Lenders will want to see evidence that the applicant is reliable at repaying finance, and a parent on the mortgage can provide that assurance. However, there are some potential pitfalls to be aware of and discussed with an experienced property expert. For example, if you fall into arrears and your parents are unable to cover them, the lender can repossess any other properties your parents own, as well as the one you're buying together.

Another issue is the age of the parents. If they are likely to retire during the term of the mortgage, lenders may impose a maximum age cap, or your parents will need to prove that their income from a pension or other sources is sufficient to continue covering the repayment post-retirement. A joint mortgage with parents can also limit the mortgages offered, as they would need to be on the deeds/title and own the house but not live there. There could also be capital gains tax issues when selling the parents' share. There would need to be careful consideration of how the ownership is defined as either Joint Tenants or Tenants in Common with a defined share of the property.

If you are considering a joint mortgage with your parents, it is important to seek advice from an independent expert or broker, who can talk through the risks and explain the tax implications and other details.

Pros and cons of joint mortgages

A joint mortgage is when you take out a loan to purchase property with one or more people. It is mostly chosen by young couples buying their first home, but it can also be used by groups of people to finance larger purchases, such as hotels. Joint mortgages allow individuals to pool their resources and increase their borrowing power, making it easier to purchase a more expensive property.

Pros of Joint Mortgages

Joint mortgages have several benefits:

• The combined income of each party is taken into consideration when assessing the total sum to be loaned, allowing for a larger mortgage and hence a larger home.
• A parent can help a child obtain a mortgage by agreeing to enter into such an arrangement.
• Each individual involved in a joint mortgage can claim tax relief on their payments.
• It may be easier to save a larger deposit as multiple people are contributing.
• If you are unable to make the mortgage payment, your partner or someone else on the mortgage may be able to cover your share.
• Joint borrowing increases your loan eligibility and makes repaying the loan easier.

Cons of Joint Mortgages

However, there are also some potential drawbacks and risks to joint mortgages:

• All co-owners are equally responsible for the payment of the mortgage. If one owner cannot make their repayments and you cannot afford to cover them, this could put the property at risk of repossession.
• If you take out a mortgage with someone who has poor credit, you may not be able to borrow as much as expected, and you may also face higher interest rates on the mortgage.
• In the case of a couple's break-up, all co-owners remain responsible for the payment of installments until a solution is found to release one or more co-owners.
• In the event of the death of one of the joint owners, the heirs may have to take over the debt or sell the house to settle the outstanding debt.
• There is a potential for conflict between joint owners.

It is important to carefully weigh the pros and cons before deciding on a joint mortgage and to discuss possible scenarios with a financial or legal professional.

Lender expectations

Lenders typically expect a down payment on a mortgage, which is an upfront sum paid by the buyer when purchasing a home. This is because very few first-time home buyers can afford to pay for homes using cash, so they take out a mortgage loan to finance the purchase. The down payment represents a percentage of the total purchase price, and the borrower finances the remainder of the balance through a loan. A higher down payment reduces the loan amount and the interest accrued over time. The down payment also acts as a "cost of entry" for a loan, proving the borrower is committed to the loan.

The amount of the down payment depends on the type of loan, the lender, and the borrower's finances. There is a common misconception that a 20% down payment is required for a home purchase. While this is the threshold many lenders use for requiring mortgage insurance on a conventional loan, it is not a mandatory minimum. In fact, in 2023, the median down payment for first-time home buyers was 9%, and some government-backed loan programs do not require any down payment at all. A larger down payment is beneficial as it reduces the lender's risk and can result in better interest rates, lower monthly payments, and no mortgage insurance. However, a smaller down payment may be preferable for those who want to start building equity sooner rather than saving for a larger down payment.

When applying for a joint mortgage with parents, there are a few additional considerations. Lenders calculate mortgage caps based on a multiple of annual income, so a joint mortgage can boost the prospects of first-time buyers by adding financial weight to the application. However, lenders may be cautious about lending to parent-child applicants, especially if the parents are approaching retirement age during the term of the mortgage. In this case, lenders may impose a maximum age cap or require proof of sufficient income from pension or other sources to continue covering repayments post-retirement. It is important to seek advice and discuss potential pitfalls with a property expert before proceeding with a joint mortgage application.

Overall, while lenders expect a down payment on a mortgage, the specific amount is flexible and depends on various factors. The down payment should be considered in the context of the borrower's financial goals and ability to qualify for the loan.

Qualification requirements

Credit Score

A higher credit score will generally qualify you for better financing, lower interest rates, and a smoother approval process. Some mortgage programs have minimum credit score requirements, so it is important to know what these are and work on boosting your score if needed. You can request a free copy of your credit report at www.annualcreditreport.com and, if necessary, develop a plan for improving your report. A qualifying FICO® Score of at least 620 points is required for most types of loans, but if your score is lower than this, you may still qualify for a Federal Housing Administration (FHA) loan or Department of Veterans Affairs (VA) loan.

Income

Stable and consistent income is a foundational element when considering mortgage qualification. Lenders will assess the nature and stability of your income, with regular salary or wage earnings viewed more favourably than sporadic or inconsistent income. A higher income can qualify you for a larger loan amount.

Debt-to-Income Ratio

Lenders will also consider your debt-to-income ratio (DTI) to determine how much of your income can go towards your monthly debt, including your mortgage and all other monthly debt payments. The generally accepted recommendation is for a ratio of 36% or lower. Your DTI ratio is the total of your mortgage interest, principal, insurance payment, property taxes, and all recurring debt payments, such as auto loan/lease payments and credit card payments, divided by your gross monthly income.

Down Payment

The down payment is the initial upfront portion of the total purchase price of the property. The more you can invest upfront, the lower the loan amount and the lower the potential risk for the lender. A substantial down payment can lead to better interest rates and eliminate the need for private mortgage insurance (PMI). However, if you can't afford a large down payment, there are specific loan programs, like FHA loans, designed with lower down payment requirements.

Gift funds for down payments

Using gift funds for a down payment can be a great way to help buyers struggling to save up the full amount on their own. However, there are specific rules and guidelines about who can give the money, how much, under what conditions, and what paperwork is required.

Firstly, it's important to note that not everyone can give you money for a down payment. The donor must not be affiliated with the builder, developer, real estate agent, or any other interested party to the transaction. Some lenders may also have specific restrictions on who can provide gift funds. For example, with conventional loans, acceptable sources are limited to family members and romantic partners, while FHA loans allow for gifts from family, friends, employers, or charitable organizations.

The rules for using gift funds also depend on the type of loan. With conventional loans, lenders usually allow gift money for some or all of the down payment, closing costs, and financial reserves. FHA loans are government-backed loans intended for first-time or low-to-moderate-income families, and they also accept gift money for down payments, closing costs, or reserves. USDA loans, on the other hand, do not permit gift funds to count as financial reserves, but they can cover the loan's closing costs.

When using gift funds for a down payment, you'll typically need to provide a gift letter stating the amount, the donor's contact information, and that the money is a gift and will not be repaid. You may also need to provide documentation of the fund transfer and evidence that the donor has sufficient funds. If you're pooling gift funds with your own funds to make the down payment, you may also need to provide documentation of shared residency with the donor.

It's important to note that gift funds for a down payment come with certain risks and considerations. For example, if you're applying for a joint mortgage with your parents, their age and retirement status may impact the approval of your application. Additionally, if you fall into arrears and your parents are unable to cover the payments, the mortgage provider can repossess their properties. Therefore, it's crucial to seek advice and carefully consider all aspects before proceeding with a down payment using gift funds.

Frequently asked questions