What Is a Down Payment?
A down payment is a sum of money that a buyer pays in the early stages of purchasing an expensive good or service. The down payment represents a portion of the total purchase price, and the buyer will often take out a loan to finance the remainder.
- A down payment is money paid upfront in a financial transaction, such as the purchase of a home or car.
- Buyers often take out loans to finance the remainder of the purchase price.
- The higher the down payment, the less the buyer will need to borrow to complete the transaction, the lower their monthly payments, and the less they'll pay in interest over the long term.
- Depending on the borrower and the type of purchase, lenders may require down payments as low as 0% or as high as 50%.
How Down Payments Work
A common example of a down payment is down payment on a house. The home buyer may pay 5% to 25% of the total price of the home upfront, while taking out a mortgage from a bank or other financial institution to cover the remainder. Down payments on car purchases work similarly.
In some cases, the down payment is not refundable if the deal falls through because of the purchaser.
A down payment may also be referred to as a deposit, especially in England, where 0% to 5% deposit mortgages for home buyers are not uncommon.
Examples of Down Payments
In the United States, a 20% down payment on a home has been the traditional standard. However, mortgages with 10% or 15% down are also available, and there are ways to buy a home with as little as 3.5% down, such as with a Federal Housing Administration (FHA) loan.
One situation in which a larger down payment is often necessary is with cooperative apartments, or co-ops, which are common in some cities. Many lenders will insist on 25% down, and some high-end co-op properties may even require a 50% down payment, although that is not the norm.
Of course, you can also put down more than the minimum if you wish to.
A down payment of 20% or more may get you a lower interest rate on an auto loan.
For car purchases, a down payment of 20% or more can make it easier for a buyer to be approved for a loan and get a better interest rate and other terms. Car dealers may also offer promotional terms of 0% down for buyers who qualify. While that means no down payment is necessary, it may also mean the lender will charge a higher interest rate on the loan.
Benefits of a Large Down Payment
Making as a large a down payment as you can reasonably afford will decrease the amount of interest you'll pay over the life of the loan, lower your monthly payments, and, in some cases, make insurance unnecessary. Here are the details:
The greater your down payment, the less you'll have to borrow and the less you'll pay in interest. For example, if you borrow $100,000 on a loan with a 5% interest rate, you'll pay $5,000 in interest the first year alone. However, if you put down an additional $20,000 and borrow only $80,000, your first-year interest will be just $4,000—a savings of $1,000.
The difference is even more dramatic over the long term. For example, borrowing $100,000 at 5% interest would cost you $93,256 in interest over a 30-year period. Borrow just $80,000 and your total interest cost will be $74,605—nearly $20,000 less.
In addition, a lender may offer you a lower interest rate on your loan if you are able to put more money down because you represent less of a risk.
Similarly, a larger down payment will reduce your monthly outlay. Using the same example as above, a $100,000 loan would require monthly payments of $537, while an $80,000 loan would reduce that to $429.
In the case of home buying, a larger down payment can help you avoid having to pay for private mortgage insurance (PMI), which reimburses your lender if you don't make your loan payments. If you can put down 20% or more, your lender will generally not require PMI. (If you can't afford a 20% down payment and are forced to buy PMI, bear in mind that you can ask your lender to drop that requirement once your equity in the home reaches 20%.)
How Much Do I Need for a Down Payment?
Your lender, or the seller if you're not financing the purchase, may set a minimum for your down payment. That will generally be a percentage of the purchase price. While the amount may be negotiable in some instances, that's likely how much you'll need to scrape up to proceed with the transaction.
Beyond that, however, putting more money down can lower your monthly payments and total costs, as described above. So, if you need to keep your monthly budget below a certain limit, you may have to make a larger down payment for that reason.
Alternatives to a Large Down Payment
If a large down payment is beyond your reach, there are alternatives. As mentioned earlier, loans with lower-than-customary down payments are widely available, although they can be more costly over time.
One money-saving tactic if you can't come up with a large down payment on a home is to borrow as much as you need to but plan to make additional payments toward your mortgage principal as time goes by. That will reduce the amount you owe and also allow you to pay off your mortgage faster if that's your goal. You may be able to do that, for example, if your income rises over the years. This is often referred to as making accelerated payments or accelerated amortization.
Another money-saving move is to refinance your mortgage when you're in a financial position to do so and to make a larger down payment on the new loan.