What Is a Down Payment?
A down payment is a type of payment, often in cash, made in the early stages of a purchase of an expensive good or service. The payment represents a percentage of the full purchase price. In some cases, the down payment 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.
- A down payment is payment made as part of a large purchase in the early stages of a financing arrangement.
- The higher the down payment, the lower the interest payments will be on the remainder of the loan.
- Lenders may require a varying amount as a down payment (as low as 3.5% and as high as 50% in the United States), depending on the borrower and the purchase.
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 covers the remainder of the costs through a mortgage loan. Down payments on car purchases work similarly.
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 entitles 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.
For 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, although that usually means a lender will charge a fairly high interest rate on the loan.
When a borrower makes a down payment on a purchase and uses a loan to pay for the remainder, the borrower instantly reduces the amount of interest to be paid over the lifetime of the loan. For example, if $100,000 is borrowed on a loan with a 5% interest rate, the interest owed will be $5,000 in the first year alone.
However, if the down payment is $20,000, only $80,000 needs to be borrowed. As a result, during the first year, the interest is only $4,000, saving $1,000 in the first year. Thus, it pays to have a sizable down payment on a mortgage because it might save thousands of dollars in interest over the loan’s lifetime. Mortgage calculators are useful when calculating interest and the total cost of a loan with various down payments.
Down payments also reduce monthly payments on installment loans. For example, if a borrower takes out a car loan for $15,000 with a 3% interest rate and a four-year term, the monthly payments are $332. However, with a down payment of $3,000, the buyer only needs to borrow $12,000, and the monthly payments drop to $266. That is a savings of $66 per month or $3,168 over the 48-month life of the loan.
In most cases, borrowers who put down less than 20% when buying a house must purchase private mortgage insurance (PMI). PMI is paid to a private insurance company, and the monthly payments are called PMI premiums. If the FHA secures a mortgage, the borrower pays for insurance through the FHA. However, if the borrower puts down a 20% down payment, they can avoid paying mortgage insurance premiums.
Down payments offer lenders a certain degree of assurance. If a borrower has invested in a down payment, they are 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.