When it comes to buying a house, the more money you can put down on the purchase price, the less your mortgage loan will cost. Why? Because you will pay less in interest. This is true of any loan, regardless of how large a sum you are borrowing, and 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.
A down payment on a house or condo can cost potential buyers anywhere from 5% to 20% of the purchase price.
Differing Views on Loans and Down Payments
Many personal finance gurus believe that taking out a loan for any reason, even to buy a home, is not a good idea. This is because the amount of money you’ll pay over the life of the loan makes the asset you purchased way overpriced. 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.
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 alone. But most Americans cannot afford a home without a mortgage, and paying interest is just part of the deal. According to ATTOM Data Solutions, as per its Q3 2018 U.S. Residential Property Mortgage Origination Report, "lenders originated 892,760 residential purchase mortgages in Q3 2018."
Any home mortgage that doesn’t reach the 20% loan-to-value level will have private mortgage insurance (PMI) 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, as a rule of thumb.
Auto Loans and Down Payments
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.
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.
Ways to Save for a Down Payment
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. 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.
- Experts say that 20% is the ideal amount to put down on a home or a car.
- It is possible to buy a house without a 20% down payment, but you will be responsible for paying PMI and added interest to your mortgage payment.
- Experts encourage potential homebuyers to stash enough cash to cover a down payment.
- Sticking to a budget may help you save over time for a down payment on a home or an automobile.
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. (For related reading, see "Saving for a Down Payment: Where Should I Keep My Money?")