The more money you can put down on a purchase, the less your loan will cost. That’s because you will pay less in interest. This is true of any loan, regardless of how large a sum you are borrowing. For this reason, it's important to save as much as you possibly can before making that big purchase. The question is: How much should you save? That – and your resources, of course – will determine how long it will take to reach your goal.
Differing Views on Loans and Down Payments
Many personal finance gurus believe that taking out a loan for any reason is not a good idea because the amount of money you’ll pay over the life of the loan makes the asset you purchased way over priced. Let’s say you buy a $200,000 home with a 4% interest rate; on a 30-year loan, you would pay more than $140,000 in interest. That’s a lot of money thrown away.
But it’s not that easy, right? For most of us, if we didn’t take out a mortgage, we would never purchase a home.
Others argue that the responsible use of credit is healthy. Whatever your opinion, even the experts agree that the more money you can put down, the more cost effective the loan. And that means you have to save as much as possible.
Take home mortgages. Although you can put down as little as 3.5% with an FHA loan or 5% with some other loans, you will probably pay a higher interest rate because the lender sees you as a higher risk borrower. That means the cost of the loan is unnecessarily higher.
Any home mortgage that doesn’t reach the 20% loan-to-value level will have private mortgage insurance added to the monthly payment. That means that you will pay between .5% and 1% of the loan amount annually for this insurance. For this reason alone, it’s best to put at least 20% down for a mortgage. (See: Buying a Home: Calculate How Much Can You Afford.)
The same principle is true for car loans. You don’t have to worry about PMI on an auto loan, but cars depreciate fast. If the loan stretches out too many years, you risk finding yourself owing more money on the loan than the car is worth. (Check out: How Interest Rates Work on Car Loans.) Car gap insurance can help against that risk, but you're better off not putting yourself in that situation in the first place. That is why experts recommend at least a 20% down payment on any auto loan. If you can’t afford that large a down payment on the car you want, consider looking for a cheaper model to keep the cost of the loan within your price range.
How to Save
A 20% down payment on a car loan or home mortgage is a large amount of cash, and for many households it isn’t practical. Still, you should attempt to reach these levels.
In the case of a car, the down payment doesn't necessarily have to be in cash. Dealers will often lower the price of a new car if you trade in your old automobile as part of the deal. Or you could sell your car privately to raise money. The same is true for a mortgage. Selling your current home at a profit becomes the money you use for your down payment. Don’t take the first offer you receive if it’s below market value. Better to wait a little longer and get a fair sale price so your down payment is larger.
If you’ve barely saved anything, the hard truth might be that you need to slow down and be patient before making that big purchase. Create a budget for yourself that allows you to save as much as you can each month. (For more, see our tutorial: Budgeting Basics.) Also look through your home and see what you can sell to raise money. You may have more value than you think tied up in your belongings.
You also might consider taking a part-time job or doing freelance work to earn extra money to put aside for your purchase. To motivate yourself, spend some time calculating how much you could save over a year if you worked a second job.
The Bottom Line
One thing is certain: If you’re serious about making a big purchase in a financially responsible way, it’s going to take some radical action. Live as lean as possible and delay the purchase until you reach your financial goal. Too many people purchase before they’re financially ready and create extra stress and problems for themselves. Slow down, save as much as you can and then make your dream purchase. You’ll be happy you waited.