In most cases, you’ll run into the need for a down payment when you’re trying to get a loan for land, a home, car, boat or an airplane. Basically, any large purchase for which you will need financing to complete will typically require you pay a portion of up front to reduce the amount of the loan you’ll need to complete the transaction.
So, now that we’ve established what they are, here’s how down payments work.
Let’s say you’d like to buy a condominium with a purchase price of $300,000. Mortgage lenders generally prefer to see you come up with at least 20 percent of the price on your own. In this case, that would be $60,000, meaning your actual loan amount would be $240,000. That $60,000 is considered your down payment on the loan.
While 20 percent is preferred, some lenders are OK with less. However, if you find a lender willing to go under 20 percent, they’re going to want you buy an insurance policy to ensure repayment if you default on the loan. This is called Private Mortgage Insurance (AKA PMI), the cost of which will be added to your monthly payment.
Typical down payments for vehicles run in the 20 percent range as well, and you can get credit insurance for those too. However, it’s usually optional in those cases.
What Down Payments Do
As we mentioned above, the primary purpose of a down payment is to reduce the amount of exposure a lender has. Or, said differently, it invests you more in the purchase. Walking away from a situation becomes more difficult if you’ll lose $60,000 as a result of doing so. This means the down payment also serves as insurance of a sort for the lender.
Yes, there are sometimes circumstances in which you might seem to have no choice but to walk away. But it’s always a good idea to consult a company like Freedom Debt Relief before you default on a home loan. While they can’t help with secured debts such as a mortgage, they can help you reduce unsecured obligations such as credit card debt to free up cash to make your mortgage payments.
Other functions of down payments include reducing the amount of your monthly payment and lowering your total interest costs.
The Bigger the Better
While 20 percent is the norm, you’re free to pay as much as you’d like. In fact, large down payments can make it easier for you to get a loan if your credit score is less than stellar. The more money you’re willing to pay toward the purchase, the more likely you are to find a lender willing to work with you.
With good credit, a larger down payment will help you qualify for an even lower interest rate. Another benefit of a large down payment is a lower monthly payment. This can be a tremendous benefit if you need to get a subsequent loan for a vehicle, as your debt to income ratio will be lower because of the smaller mortgage payment.
Finally, that down payment money represents the portion of the asset you own. In other words, that money doesn’t just go into the seller’s pocket, it also becomes part of the equity you have on the home. Let’s say the asset cost $300,000. You put $60,000 down and after five years the value of the asset appreciates to $315,000. You now have $75,000 worth of equity in the property against which you can borrow to make another purchase.
The Bottom Line
Understanding how down payments work is key. The lender’s risk is reduced. Your repayment obligation is lowered. You’ll get a better interest rate and you can build equity faster. Ultimately, down payments benefit everyone in the transaction.