Most home purchases are financed by a mortgage, which is a loan specifically intended for the purchase of a home. Some buyers use a personal loan to purchase a home or to help them purchase a home. This usually happens for one of two reasons:
- You are purchasing a very small or inexpensive home, or
- You wish to use a personal loan to help you fund your down payment.
In each of these cases, the use of a personal loan is subject to the conditions of the lender and the seller. It’s not always a good idea, but it may be an option that you can consider when buying a home.
What’s the Difference Between a Personal Loan and a Mortgage?
There are important differences between personal loans and mortgages:
- A mortgage is a secured loan. Your home serves as collateral for the loan and the lender can foreclose and take the property if you don’t pay. A personal loan is unsecured. There is no collateral for the lender to seize if you don’t pay.
- Mortgages usually have much longer terms than personal loans. Mortgages typically come with terms of 15 or 30 years. Most personal loans have to be paid back in one to five years.
- Mortgages usually carry much lower interest than personal loans. The average 30-year fixed-rate mortgage interest rate in late Feb 2020 was 3.65%. The average rate on a personal loan Jan. 2020 was 9.41%, with some rates as high as 36%.
Mortgages tend to be cheaper than other loans because the US government is heavily involved in mortgage lending. The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) purchase mortgages and guarantee them in a secondary market, pushing more capital into the mortgage market and lowering rates. A personal loan is just between you and the lender.
When to Consider Buying a Home with a Personal Loan
In most cases, it is just not practical to use a personal loan to buy a home. The rates are too high, and the terms are too short, making the monthly payments on a large loan very expensive.
There is one exception: If you are considering a very small house or a mobile home a personal loan may be an effective method for financing your purchase. This is because:
- Tiny homes and mobile homes may carry prices below the minimum loan of many dedicated mortgage lenders.
- Some lenders offer personal loans specifically designed for the purchase of small, inexpensive residences.
- From the seller’s perspective, a purchase financed by a personal loan is a cash offer. That can make your offer attractive to sellers. You can make an immediate offer and they won’t have to wait for a mortgage to be processed.
Be sure to shop for several offers and evaluate the loan proposals carefully, as you would with any personal loan.
Can I Use a Personal Loan to Finance my Down Payment?
Many people find a down payment to be a significant obstacle to buying a home. The ideal down payment is 20% and it can be difficult for many buyers to raise that much money, especially if they are paying student loans, a car loan, and credit card debts.
Some potential home buyers may consider using a personal loan to fund a down payment. In most cases, this is not possible, and even when it is possible it may not be desirable.
Lenders have several reasons for discouraging the use of personal loans to fund a down payment, including:
- Some mortgage financiers like Fannie Mae will not accept a mortgage if the down payment is funded with a personal loan.
- A personal loan will increase your debt-to-income ratio. You’ll be taking on a mortgage and a large personal loan at the same time, a major increase in your debt load.
- The lender may conclude that if you haven’t been able to save for a down payment, you may not be able to consistently make your mortgage payments.
- Your lender will probably ask you to disclose the source of your down payment. They may require a Verification of Deposit form from your bank so that they know how long you’ve had the down payment money on deposit. A borrower cannot take out a personal loan and claim that the cash was savings, because the loan will appear on the borrower’s credit report.
If your mortgage lender is willing to accept a personal loan as a source for your down payment, you will have to decide whether you’ll be able to make the personal loan payments and the mortgage payments, and you’ll have to shop very carefully for the best terms on a personal loan. You may conclude that it’s better to delay your home purchase until you can save for a down payment.
Alternatives to Using a Personal Loan for a Down Payment
If you have not been able to save enough for the recommended 20% down payment, you do have other alternatives.
- FHA Loans. Loans insured by the Federal Housing administration require down payments as low as 3.5% for qualified borrowers, but you will be required to pay for private mortgage insurance.
- VA Loans. If you are a Veteran, in active duty military service, or a qualified spouse you may be eligible for a loan through the Veteran’s Administration (VA). These loans have no down payment, but there is a funding fee, which can be waived in some circumstances.
- USDA Loans. The US Department of Agriculture offers insured home loans to qualified borrowers in many rural and suburban areas. These loans have no down payments but may not be available in your area.
- HomeReady. Fannie Mae’s HomeReady program allows qualified home buyers to get mortgages with as little as 3% down. You will be required to get private mortgage insurance.
- Alternative Lenders. Some online lenders and even some national banks may offer conventional mortgages with low or no down payments. You may be required to pay for private mortgage insurance, and your monthly payments may be larger than they would with a down payment.
- Piggyback Loans. A piggyback loan involves taking out two mortgages at the same time. One mortgage is often for 80% of the home’s value, the other is for 20%, and is used as the down payment. These loans may have higher interest rates and higher monthly payments than conventional mortgages with a down payment.
- Retirement fund loans. You may be able to borrow from your retirement funds, especially if you have a 401(k). There may be restrictions. You will not earn interest on the amount borrowed until it’s paid back, and if you don’t pay it back you will have to report it as income.
- Gifts. Sometimes family members are willing to chip in all or part of a down payment as a gift. They may have to submit a letter certifying that the payment is not a loan, and some lenders may have restrictions on the percentage of a down payment that can be funded by a gift.
- State or Local Down Payment Assistance Programs. Some states and cities have down payment assistance programs, often specializing in assisting first-time homebuyers. You may have to meet program-specific qualifications. Search online or ask realtors in your area about programs that might help you.
Each of these options has advantages and disadvantages, and you’ll have to consider them carefully and do your research before making a commitment.
Using a personal loan to purchase a home or fund a down payment is unusual and in many cases, it is not advisable. There are some cases in which it could be a viable option for some home buyers. If you believe that your purchase is one of those cases, look into your options carefully and consider alternatives before making a decision.