What to Consider When Using Gift Funds for Your Down Payment on a Mortgage
You're ready to buy a home, but understand that you need to have a good chunk of savings ready for this big milestone.
And depending on your mortgage program, you’re required to give the bank a down payment.
But what if you don’t have enough cash for a down payment? Is home buying off the table for you?
Many home loan programs allow borrowers to use gift funds for their down payment when taking out a mortgage.
What are Gift Funds?
Simply put, this is a cash gift that you can use for a home purchase.
Buying a home has always involved mortgage-related expenses, namely the down payment and closing costs.
Closing costs refer to lender and third-party fees associated with getting a home loan.
- loan origination fee
- discount points
- prepaid items
- the appraisal
- title search fees,
- attorney fees
- and more
Sometimes, closing costs are just as expensive as the down payment. This is why some people struggle to save enough money for a home purchase.
The traditional down payment for a house is 20 percent. But, you’re not required to put down this much.
You can buy with far less.
Conventional home loans require as little as 3 percent to 5 percent down. Meanwhile, FHA home loans require as little as 3.5 percent down.
Closing costs average 2 percent to 5 percent of the sale price, depending on where you live.
But although mortgage lenders have relaxed their down payment requirements, many would-be homeowners still struggle to save enough cash.
And as a result, they delay a purchase.
The ability to purchase a home using a financial gift, however, can put homeownership within reach.
Benefits of Using a Gift for a Down Payment
Not only does a financial gift put a home within reach, but it also allows you to purchase sooner rather than later.
Home prices and mortgage interest rates can fluctuate from year to year.
And unfortunately, when you put off buying a home, there’s the risk of paying a higher sale price in the future, or paying a higher mortgage rate. Both factors increase the overall cost of a home.
Your mortgage payment will be higher, and you’ll pay more interest over the life of the loan.
Naturally, you’ll want to take advantage of the market when prices and rates are lower.
Using a financial gift can make this happen.
Rather than save up and wait five or 10 years to buy a home, you can use a gift and purchase now.
Additionally, using a financial gift for a home purchase might prevent draining your savings account.
As a general rule of thumb, you should never deplete your savings for a home purchase.
Unexpected repairs and maintenance will occur.
Or, you might lose your job or take time off from work due to an injury or illness after purchasing the home.
So it’s wise to maintain a cash reserve after closing on your mortgage.
By keeping some money in the bank, it’ll be easier to make your mortgage payment during hardships.
Let’s say you need $15,000 for a home purchase, yet you only have $15,000 in saving.
Rather than empty your account, use a portion of your own savings to purchase the home, and then use a financial gift to cover the difference, if available.
It’s a win-win.
You’re able to get your foot in the door as a homeowner “and” maintain a safety net.
Depending on how much you receive as a financial gift, gift funds can also alleviate the need for mortgage insurance.
This type of insurance is required on most mortgages without a 20 percent down payment.
Mortgage insurance protects your lender in the event of default, yet you’re responsible for the premiums. If you combine your own funds with a financial gift, you might be in a position to put down 20 percent.
The ability to avoid mortgage insurance results in a lower monthly payment.
Additionally, a sizable down payment can help you qualify for a better interest rate, resulting in additional savings — both monthly and over the course of your loan.
Which Mortgage Programs Allow Gifts?
The good news is that several programs allow financial gifts for a home purchase. Two popular programs include FHA and conventional home loans.
Conventional home loans
Conventional home loans are insured by Freddie Mac or Fannie Mae.
Qualifying for these home loans typically requires a minimum credit score of 620.
Most people need at least a 5 percent down payment.
However, some conventional products allow first-time homebuyers and low-to-moderate income borrowers to purchase with as little as 3 percent down.
If you’re buying a one-unit primary residence with a conventional home loan, all funds needed to complete the purchase can come from a gift.
If you’re buying a multi-unit residence with a conventional home loan, you must contribute a minimum of 5 percent from your own funds.
FHA home loan
Similarly, all funds needed to complete a home purchase can come from a gift with an FHA home loan.
The exception is if your credit score is less than 620.
Borrowers with a credit score between 580 and 619 must contribute a minimum of 3.5 percent from their own funds.
USDA and VA home loans don’t require a down payment.
Even so, you may be responsible for paying your own closing costs.
In this case, you can also use a financial gift to cover these expenses. Minimum contribution requirements vary by lender.
What are the Rules for Using Gift Funds?
Even though using a financial gift for a home purchase is an option, make sure you understand the rules and guidelines before proceeding.
Source of gift funds
Be mindful that mortgage lenders don’t allow gifts from everyone.
The donor must be approved by the bank and meet the eligibility requirements of the mortgage program.
In most cases, the donor must be a family member. This can include a spouse, a fiancé, a sibling, a grandparent, an aunt or uncle, or another relative.
Sometimes, mortgage lenders allow non-relatives to gift funds. This can include a close friend or a godparent. Be prepared to explain your relationship.
A charitable organization or your employer might also be permitted to provide gift funds, under certain circumstances.
There are, however, people who aren’t allowed to gift funds for your home purchase. This includes any individual with an interest in the property. Ineligible donors include the home seller, your mortgage broker, or the real estate agent.
Bear in mind:
The gift must come from the donor’s own funds.
The same way your mortgage lender will request copies of your bank account statements to verify assets, they’ll also need to see bank statements from your donor to verify the source of the gift.
You’re not allowed to borrow money to purchase a home. So any funds you receive for a home purchase must be an actual gift.
So that this is abundantly clear, your donor must provide your mortgage lender with a gift letter.
In this letter, your donor must explicitly state that repayment isn’t required.
The gift letter must also include other pertinent information, for example:
- the donor’s name, home address, phone number, and their relationship to you
- the address of the property you’re buying
- the exact amount of the gift
- the source of the gift (bank account, retirement fund, etc.)
- the date the recipient received the gift
- the donor’s signature
A paper trail is also important.
So if the donor transferred or wired funds into your account prior to closing, be prepared to provide an updated bank statement confirming this transaction.
The good news about receiving gift funds if that you’re not responsible for paying taxes on the money.
There could be tax implications for your donor, though.
Depending on the amount of the gift, your donor might have to pay a gift tax.
The annual gift tax exclusion for 2020 is $15,000.
Therefore, the IRS allows each taxpayer to give up to $15,000 per person, per year without having to pay a gift tax.
Your donor will have to file a gift tax return if the amount of your gift exceeds the annual exclusion.
Buying a home is a major milestone.
But saving a down payment can take years, and this expense remains one of the biggest obstacles to homeownership.
Fortunately, you don’t have to come up with the funds alone.
If you need help with all or a portion of your down payment and/or closing costs, a financial gift can get your foot in the door.
This can help you purchase a home while prices are still affordable. As a result, you’re able to start building equity sooner and grow your net worth earlier in life.