A down payment is an amount of money a borrower pays for a percentage of property or an asset they intend to purchase through a finance company. This asset is usually expensive, so a loan is required to complete the purchase.
What Is A Down Payment?
One common example of a down payment would be the purchase of a real estate property, such as a home. Most buyers require a mortgage to complete such a purchase, and in most cases, one of the conditions to get approved for one is to have a down payment that covers a percentage of the property’s value.
The size of a down payment varies from one lender to another, and it may also fluctuate depending on the borrower’s credit situation, income, and job situation. The down payment amount can be calculated by multiplying the percentage of down payment by the market value of the property being bought.
Benefits of a Large Down Payment
Some people prefer to save a significant amount of money to allow them to pay a larger down payment, and doing so has the following advantages and disadvantages:
- No private mortgage insurance (PMI): For down payments lower than 20% of the property’s value, the borrower must often purchase private mortgage insurance (PMI) to reduce the lender’s risk carried. Therefore, one of the benefits of a larger down payment is to avoid this expense, which can be as high as 0.5% to 1% of the value of the loan per year.
- Smaller installments: Since the loan amount will be lower as a result of the higher down payment, the monthly mortgage payments will typically also be lower. This allows the borrower to save money on interest charges.
- Lower interest rates: A larger down payment may result in a lower interest rate, as the loan-to-value percentage will be lower as well as the risk carried by the lender.
- Higher equity on the property: A property that is financed with a higher down payment provides a larger equity portion to the borrower, which can be used as collateral for other financing instruments or to strengthen the borrower’s Balance sheet.
- Longer saving period: Saving for a larger down payment requires more time, and in the meantime, market prices or interest rates could rise. The longer the waiting period, the higher the risk that certain conditions vary negatively, exposing the borrower to unnecessary expenses.
- Risk of using the funds for something else while saving: A prospective borrower looking to save a larger down payment may encounter an emergency or a business opportunity, prompting them to use the funds for a different purpose.
- Opportunity costs: The cost of investing a larger percentage of money as a down payment for a property might not be beneficial from a financial standpoint if other investment opportunities create more value by comparison. In this sense, borrowers should evaluate the opportunity cost involved in putting down a larger sum compared to investing the funds elsewhere.
Benefits of a Small Down Payment
Additionally, there are also some pros and cons associated with small down payments, including:
- Shorter saving period: A smaller down payment reduces the length of the borrower’s saving period, which also reduces the time it’ll take to complete the purchase. This is a positive situation for individuals who spend significant amounts in rent, as they can quickly shift their housing situation, saving money as a result.
- More funds for improvement: If the borrower has already saved a large down payment, they could decide to stick with the minimum required by the lender to use the remaining funds to remodel or further improve the property, which could ultimately boost its market value.
- Available funds for other investments: A smaller down payment would provide more funds for investment purposes to generate some extra cash to help with mortgage payments and other related expenses. If the income resulting from these operations is higher than the interest charges of the mortgage, the situation can be profitable for the borrower.
- Private mortgage insurance (PMI) costs: A down payment lower than 20% usually requires that the borrower purchases PMI to reduce the risk carried by the lender. The cost of PMI is high (up to 1% of the property value per year), and for this reason, smaller down payments could be more costly in the long run.
- Higher interest rates: Lower down payments increase the lender’s exposure to market risks and the risk of a default, which could ultimately result in higher interest rates for the borrower. If a larger down payment is possible, and the result is a lower interest rate, the borrower should evaluate the possibility of increasing it to reduce their borrowing costs.
- Lower equity: A lower down payment means a lower equity portion for the borrower, which reduces the chances of using this asset as collateral for other types of credit.
Types of Loans that Require a Down Payment
The most common loans that require a down payment are:
- Mortgages: With a mortgage, the financial institution uses the underlying property (residential, commercial, or industrial) as collateral to back the loan. Most lenders require that the borrower pays a minimum down payment (20% in the U.S. in most cases) to share the risk associated with the transaction. However, some lenders may also decide to extend no-down-payment loans to certain individuals who meet their criteria.
- Auto Loans: Auto loans are used to purchase a vehicle, and they are available to both individuals and companies. Lenders also require a down payment in most cases, and the loan is backed by the vehicle’s value. Under some specific circumstances, lenders may also waive the down payment requirement for some individuals or companies, but this may result in higher interest rates.
Financing a Down Payment
Mortgages are the most common way of financing the remaining percentage of the property’s value, but the down payment can also be financed by using some of these sources:
- Bridge loans: A bridge loan is an intermediate financing tool that borrowers may use for a down payment. Bridge loans typically have a credit term of up to 12 months, allowing the borrower to cover the down payment with a series of installments.
- Federal or municipal aids: Some programs designed by states, municipalities, or the federal government itself assist prospective homebuyers in securing the amount of down payment. The degree of assistance provided, and the requirements to access this aid, vary from one institution to the other, and, therefore, borrowers must research the conditions of each alternative depending on their state of residency.
- Friend or family: Borrowers might also rely on their loved ones to gather the funds required for a down payment.
- Retirement funds: If the borrower has saved money through their retirement account, these funds could be used to cover the down payment either partially or totally. Nevertheless, certain tax considerations and penalties might apply and should be considered before using this source.
Down Payment Statistics in the U.S.
By Q3 2019, more than $375 billion had been issued for the mortgages of residential properties, and nearly 56% of the down payments were lower than 20% of the property’s market value. This means that borrowers tend to choose smaller down payments rather than large ones (more than 20%).
On the other hand, considering that the average sales price of homes in the United States is approximately $362,700, and the median household income in the U.S. as a whole is estimated to be $61,400, it would take the average American household nearly 12 years to save a 20% down payment by saving 10% of their pre-tax income each year.
Additionally, the average interest rate for a 30-year fixed-rate mortgage in the U.S. is currently around 3% and 5%, depending on the borrower’s credit and financial situation.
No Down Payment Mortgages
Previous to the financial crisis of 2007-2008, lenders were more willing to extend mortgages and other secured loans to individuals without requiring any down payment. However, since subprime mortgages were identified as one of the potential causes for the crisis, lenders have now increased their requirements, even though the statistics suggest that a significant portion of mortgages are approved with less than 20% down payment.
On the other hand, while there are some advantages to these no-down-payment loans, there are also some cons that borrowers should consider:
- For individuals who are in a rush to purchase a home, no down payment mortgages can be a suitable alternative to quickly change their housing situation.
- In a low-interest-rate environment, a person could use a no down payment loan as a way to finance the purchase of a property cheaply and invest the funds they have already saved, which could provide enough money to cover the interest charges.
- Since no down payment loans expose lenders to significant risk, their approval is often limited to individuals with an excellent credit situation and high income.
- These loans often require that the borrower purchases private mortgage insurance (PMI), which could end up being an expensive burden considering it’s an annual expense.
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