What is a 'Down Payment'
A down payment is a type of payment made in cash during the onset of the purchase of an expensive good or service. The payment typically represents only a percentage of the full purchase price; in some cases, it is not refundable if the deal falls through. In most cases, the purchaser makes financing arrangements to the cover the remaining amount owed to the seller.
BREAKING DOWN 'Down Payment'For example, many homebuyers pay down payments equal to 5 to 25% of the total value of the home, and a bank or other financial institution covers the remainder of the costs through a mortgage loan.
Down payments decrease the amount of interest paid over the lifetime of the loan, lower the monthly payments and provide lenders with a degree of security.
How Down Payments Affect Interest
When you make a down payment on a purchase and use a loan to pay for the remainder, you instantly reduce the amount of interest you pay over the lifetime of the loan. For example, if you borrow $100,000 on a loan with a 5% interest rate, you owe $5,000 in interest in the first year of the loan alone. However, if you have a $20,000 down payment, you only need to borrow $80,000. As a result, during the first year, your interest is only $4,000, saving you $1,000 in the first year alone.
Down payments also offer lenders a certain degree of assurance. Essentially, if a you have invested in a down payment, you may be less likely to default on the loan. Because of that assumption, mortgage lenders, in particular, may offer lower interest rates to borrowers with large down payments.
How Down Payments Affect Monthly Payments
Down payments also reduce monthly payments on installment loans. For example, imagine you buy a car for $15,000. If you take out a loan for $15,000 with a 3% interest rate and a four-year term, your monthly payments are $332. However, if you have a down payment of $3,000, you only need to borrow $12,000, and your monthly payments fall to $266. That is a savings of $66 per month or $3,168 over the 48-month life of the loan.
How Down Payments Affect Mortgage Insurance
In most cases, if you put down less than 20% when you are buying a house, you have to purchase mortgage insurance (PMI). PMI is paid to a private insurance company, and the monthly payments are called PMI premiums. If your mortgage is secured by the Federal Housing Administration (FHA), you pay for insurance through the FHA. However, if you put down a 20% down payment, you can avoid paying mortgage insurance premiums.