When you buy expensive items with a loan, you often need to make a down payment to cover a portion of the purchase price. That initial payment is often critical for getting approved, and it can affect your borrowing costs throughout the life of your loan. As a result, it’s wise to understand how down payments work so you can choose the right down payment amount.

What Is a Down Payment?

A down payment is an upfront payment you make to purchase a home, vehicle, or another asset. The down payment is the portion of the purchase price that you pay out-of-pocket (as opposed to borrowing). That money typically comes from your personal savings, and in most cases, you pay with a check, a credit card, or an electronic payment.

Down payments are often, but not always, part of obtaining a loan. For example, when you see “zero down” offers on vehicles, no down payment is required. Some home loans don’t require a down payment either. However, it is sometimes wise to make a down payment even when you don’t have to. The down payment often covers a meaningful percentage of the total purchase price (such as 20%). You pay off the remainder of the loan over time with regular installment payments unless you pay the loan off early with a large payment or by refinancing.

For example, you buy a house for $200,000. You have saved $40,000 for this purpose, so you bring a cashier’s check for a $40,000 down payment (which is 20% of the purchase price) when you close on your home loan. As a result, you’ll only borrow $160,000, which you can pay off with a 30-year mortgage.

How Much Should You Pay?

You can often choose how large of a down payment to make, and the decision is not always easy. Some people believe bigger is always better, while others prefer to keep down payments as small as possible. You need to evaluate the pros and cons and decide for yourself.

The Pros of a Larger Down Payment

A bigger down payment helps you minimize borrowing. The more you pay upfront, the smaller your loan. That means you pay less in total interest costs over the life of the loan, and you also benefit from lower monthly payments. To see how this works for yourself, gather the numbers from any loan you’re considering and plug them into a loan calculator. Experiment with adjusting the loan balance and watch how the other numbers respond.

A big down payment can help you in several ways:

  • Lower rates: You might qualify for a lower interest rate if you put more down. Lenders like to see larger down payments because they can more easily get their money back if you default on the loan. By reducing your lender’s risk, you can potentially reduce your interest charges.
  • Mortgage insurance: When buying a home, you might be able to dodge private mortgage insurance (PMI) and other fees with a bigger upfront payment of 20% or more.
  • Smaller monthly burden: Low monthly payments can make your life easier. If your income changes (due to job loss, for example), lower required monthly payments give you more wiggle room.
  • Future borrowing power: A large down payment also makes it easier to qualify for additional loans in the future. Lenders like to see that you have more than enough income to meet your monthly obligations, and they evaluate your finances with a debt-to-income ratio. Your debt-to-income ratio compares your total monthly debt payments to your pre-tax monthly income. A lower monthly payment means a lower debt-to-income ratio, which makes you look better to potential lenders.
  • Potential equity: Sometimes you can borrow against assets like your home, using the asset as collateral. The larger your initial down payment, the sooner you build a significant amount of equity in your home, which you might be able to borrow against with a home equity loan or line of credit. Your equity is the amount of your home you actually own. For example, if you have a home valued at $200,000 and a mortgage balance of $100,000, you have 50% equity in your home, or $100,000. A lender might offer you a home equity loan or line of credit for a portion of that $100,000.

The Pros of a Smaller Down Payment

A smaller down payment is appealing for one obvious reason: you don’t have to come up with as much money. Several arguments for keeping your down payment small include:

  • Buy sooner: Saving 20% for a home purchase can take years. For some, it can take decades, and that may not be acceptable in your situation.
  • Emergency reserves: If you do happen to save a significant amount, it’s scary to part with all of that money. What if something happens (your car breaks down, health problems arise, and so on)? Putting all of your free cash into a house or car means your money is tied up in something that might be hard to sell. Some people aren’t comfortable with that scenario.
  • Resources for improvements: When it comes to a home purchase, small down payments are tempting. You get to keep cash on hand for those inevitable improvements and repairs.
  • Other priorities: You might prefer to use the funds for other purposes, such as retirement savings or growing your business.

Of course, the decision is personal, and the right choice depends on numerous factors. Ideally, you’ve got a solid emergency fund to deal with any surprises and you’re not robbing from that fund to make your down payment.

Lender Requirements

It’s not uncommon for lenders to set a minimum required down payment (but you can pay more if you like). Again, a larger down payment reduces lender risk. If they foreclose on your home or repossess your auto, they don’t have to sell it for top-dollar to recover their investment.

Down payments can also have a psychological impact. They show lenders that you have “skin in the game” because your own money is at stake. As a result, you’re more likely to keep making payments, as walking away would be expensive. What’s more, a down payment shows lenders that you are willing and able to come up with a portion of the purchase price, and a track record of saving is always helpful for getting approved.

Here are common down payment requirements:

  • For home purchases: Paying at least 20% allows you to avoid paying for PMI, which protects your lender if you default on the loan. If you can’t bring 20% to the table, an FHA loan might be a viable option, requiring only 3.5% down. However, you still pay for insurance with an FHA loan, and you need to evaluate whether or not you’re in a good position to buy if you’re short on funds.
  • For auto loans: Mainstream lenders might require at least 10% down. However, some lenders are willing to allow up to 110% loan-to-value (based on Kelley Blue Book values). Your loan-to-value is the amount of your loan compared to the value of your asset.

Cash and Alternatives

In most cases, down payments come as “cash” (or more likely a check, money order, or wire transfer), but cash isn’t always required. For example, a lien on your land can sometimes function as a down payment when applying for a construction loan.

After making your down payment, you typically pay off the remaining loan balance with:

  • Ongoing periodic payments (monthly payments, for example)
  • Additional lump sum payments, if you choose to make optional payments to reduce your debt or pay the loan off early
  • balloon payment, in some cases

As with many situations, the first steps you take can sometimes help you or haunt you for years to come, so it’s essential to choose your down payment wisely. Once you’ve decided on a number, start saving up so your plan is a success.

Source: thebalance.com ~ Image: thebalance.com

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