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 represents a percentage of the full purchase price; in some cases, it is not refundable if the deal falls through because of the purchaser. In most cases, the purchaser makes financing arrangements to cover the remaining amount owed to the seller.
For example, many homebuyers make down payments of 5% to 25% of the total value of the home, and a bank or other financial institution will cover the remainder of the costs through a mortgage loan. Down payments on car purchases work in a similar fashion.
A down payment may also be known as a deposit, especially in England, where 0% to 5% deposit mortgages for some buyers are not uncommon.
How Down Payments Work
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.
In the United States, a 20% down payment on a home is the standard for lenders. However, there are ways to buy a home with as little as 3.5% down, such as with a Federal Housing Administration (FHA) loan.
A situation in which a larger down payment may be necessary is when purchasing within a co-operative property, which is common in many cities. Since a buyer of a co-operative apartment is actually buying shares in a corporation that entitle them to a corresponding home, many lenders will insist on 25% down. Some high-end co-op properties may even require a 50% down payment, although that is not the norm.
A down payment of 20% or more may get you a lower interest rate on an auto loan.
In car purchases, a down payment of 20% or more may make it easier for a buyer to get better loan rates, terms, or approval for a loan. Some dealers may offer terms of 0% down for some buyers, which means no down payment is required, though that usually means a lender will charge a fairly high interest rate on the loan.
Calculating a down payment is oftentimes a complicated endeavor. There are some areas where more careful consideration than others is needed. Down payments also offer lenders a certain degree of assurance. Essentially, if 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.
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. Thus, it pays to have a sizable down payment on your mortgage as it will save you thousands of dollars in interest over the lifetime of the loan.
If you are considering taking out a mortgage, use a mortgage calculator to calculate interest and the total cost of the loan with various down 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.
- Make your down payment as high as you can afford in order to save on interest payments on the remainder of the loan.
- Lenders may require a varying range of down payments (as low as 3.5% and as high as 50% in the U.S.), depending on the borrower and property type.
In most cases, if you put down less than 20% when you are buying a house, you have to purchase private 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 FHA, you pay for insurance through the FHA. However, if you put down a 20% down payment, you can avoid paying mortgage insurance premiums. (For related reading, see "Saving for a Down Payment: Where Should I Keep My Money?")