Can You Use a Personal Loan as a Down Payment?

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Often, the most challenging part of buying a home is coming up with a down payment. Whether your lender is allowing 3% down or you're hoping to hit 20% to reduce your monthly payments and avoid mortgage insurance, saving up all that cash isn't easy for most people. With the national average home price currently hovering around $270,000, according to Zillow, a 20% down payment would require you to save up about $54,000.

That's quite a sum, and even the lowest possible down payment may feel out of reach for cash-strapped homebuyers. Using a personal loan to cover some or all of your down payment may sound like a great solution, but it won't fly with most mortgage lenders. Here's what you need to know about using a personal loan as a down payment—plus some alternatives that may be worth exploring.

Why Can't I Use a Personal Loan as a Down Payment?

Conforming conventional loans, as well as FHA loans, do not allow homebuyers to use personal loans as down payments. Even if you find a lender and type of loan that doesn't explicitly forbid it, using a personal loan as a down payment may still not be an option. There are a couple reasons for this.

When applying for a mortgage, the lender will take a deep dive into your financial life and pay close attention to how your debt relates to your income. They'll look at your recent pay stubs and pull your credit report to calculate what percentage of your gross monthly income goes toward debt payments—something known as your debt-to-income ratio (DTI). This involves looking at all recurring monthly debt payments, from credit cards to student loans to auto loans. Personal loans are on the table as well.

Mortgage lenders generally require a DTI that's less than 43% (or 36% for some lenders). Taking out a new personal loan to use as a down payment will nudge your DTI upwards, which will likely be a red flag to lenders. In some cases, it might increase your DTI enough to put you over the eligibility threshold and disqualify you as a mortgage borrower. It could also suggest that you may not be in the best financial position to buy a home. Either case makes it unlikely that a lender will accept a personal loan as a down payment.

Instead, lenders will want to see that you've got enough money available in your bank accounts to cover your down payment. All large deposits—including funds that come in from a personal loan—will need to be verified and substantiated.

Alternatives to Using a Personal Loan as a Down Payment

If you're worried you won't be able to squirrel away an adequate down payment, take heart in knowing that many people buy homes putting down much less than 20%. In fact, the median down payment for first-time homebuyers in 2019 was just 6%, according to the National Association of Realtors. Even those who don't have their target amount saved up just yet may still have options for buying a home. Consider the following personal loan alternatives.

Hold Off Until You Can Save More

Slowing down and taking some time to increase your savings could be all it takes to get approved for a mortgage. This begins with creating a realistic budget and making a spending plan that allows you to funnel extra income toward your down payment. Cash windfalls such as tax refunds, raises and work bonuses can also help you save more money with little effort.

You'll also want to use this time to improve your credit as much as possible before applying for a mortgage. Borrowers who have strong credit and steady income may qualify for a conventional loan with only 3% down.

Explore Loans That Require a Lower Down Payment

FHA loans, which are geared to first-time homebuyers and insured by the Federal Housing Administration, approve eligible borrowers with as little as 3.5% down. There are other federally backed loans worth exploring as well. USDA loans, which are geared toward certain rural and suburban homebuyers, require no down payment at all. The same goes for VA loans, designed specifically for U.S. service members and their surviving spouses; you also won't have to pay mortgage insurance on these loans.

Consider Down Payment Assistance Programs

Borrowers can also look into down payment assistance programs to help ease the financial burden of buying a home. The National Homebuyers Fund, for example, provides grants to low- and moderate-income buyers that could be equivalent to a 5% down payment. The U.S. Department of Housing and Urban Development (HUD) also allows you to search local homebuying programs by state.

Borrow Money From a Friend or Family Member

If you have a family member or friend who's in a position to lend you money for a down payment, and you feel comfortable with the arrangement, it could be a great alternative to a personal loan. Coming up with a repayment plan ahead of time that everyone agrees to can help set the stage for a smooth experience.

Just remember that mortgage lenders will want to substantiate large deposits into your account. If the money is a loan, be prepared to clarify your monthly payments to your lender as it will factor into your DTI ratio. If the money is a gift that doesn't need to be repaid, your lender will most likely require the giver to sign a gift letter to legitimize the transaction.

How Will Getting a Personal Loan Affect My Credit?

Taking out a personal loan prior to applying for a mortgage, even if you don't plan to use it for a down payment, can affect your credit in both positive and negative ways. Since the account will show up on your credit report, making on-time payments every month can help your credit score (while making late payments will hurt it). If you use a personal loan to consolidate revolving credit card debt, you'll reduce your credit utilization ratio, one of the most important credit scoring factors—and, in turn, likely improve your credit score.

In general, it's wise to hold off on applying for new loans and credit during the mortgage application process. Doing so will result in a temporary dip in your credit score since it triggers a hard credit inquiry. It's also adding to your debt load, which could work against you when applying for a mortgage. You want your credit to be in the best shape possible when you apply, so this is an important factor to consider. Here are some other action items that can help strengthen your credit before approaching mortgage lenders:

  • Check your credit report and credit score to know where you stand and dispute any inaccurate information.
  • Pay down credit card debt.
  • Continue making timely payments on all your accounts.
  • Consider getting preapproved for a mortgage so you know how much house you can afford.

The Bottom Line

While personal loans can be a good option for consolidating debt, covering a financial emergency or paying excessive medical bills, they aren't typically allowed as a mortgage down payment. Instead, exploring loans with low down payment requirements or waiting until you've built up more savings may be your best bet. Also, don't forget you'll need to pad your savings with roughly 2% to 5% of your home loan amount to cover closing costs.

Knowing what's on your credit report can help you pinpoint opportunities to improve your credit score before applying for a mortgage. Check your credit for free with Experian to get moving in the right direction.