Choosing a Down Payment
Pros and Cons of Making a Down Payment
When you buy something with borrowed money (whether it’s a house, a car, or somebody else’s time) you’ll pay in several different ways. To get the right loan, you need to understand what those options are and how one piece of the puzzle affects the other pieces. The types of payments you make include:
- An initial down payment
- Ongoing periodic payments (monthly payments, for example)
- In some cases, additional lump sum payments (optional payments to reduce your debt or pay the loan off entirely)
As with many things, the way things get started is something that will help you or haunt you for years to come, so it’s essential to understand the initial down payment. Once you've done that, start saving up so your plan is a success.
What is a Down Payment?
The down payment is an up-front payment you make to purchase something. It is the portion of the purchase price that you pay for yourself (as opposed to borrowing). That money comes from your own personal savings and is cash you bring to the table. Of course, down payments are rarely in the form of actual paper cash. In most cases you’ll bring a check or make an electronic payment.
Down payments are often, but not always, part of a loan. When you see “zero down” offers, no down payment is required, but it might be wise to make one anyway. The down payment often covers a meaningful percentage of the total purchase price (such as 20%). The remainder of the loan is paid off over time with regular installment payments – unless you pay the loan off early by writing a large check or refinancing.
Example: you buy a house for $100,000 (ignoring closing costs). You have diligently saved $20,000 for this purpose, and you bring a cashier’s check for a $20,000 down payment (which is 20% of the purchase price). As a result, you’ll borrow $80,000, which you can pay off with a 30 year mortgage.
How much to Pay?
You can generally 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’ll have to evaluate the pros and cons and decide for yourself.
A larger down payment keeps borrowing to a minimum. The more you pay up front, the smaller your loan. That means you’ll pay less in total interest costs over the life of the loan, and you’ll also enjoy lower monthly payments. To see how this works for yourself, grab the numbers from any loan you’re considering and plug them into a loan calculator. Experiment with changing the loan balance and watch how the other numbers adjust.
A large down payment can help you reduce costs in more than one way. For example, you might get 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 (and they charge more when their risk is greater). You might also dodge mortgage insurance and other fees with a bigger up-front payment.
Having low monthly payments makes life easier in the future. If your income changes (due to job loss, for example), lower required monthly payments give you more wiggle room. What’s more, low payments make it easier to get additional loans in the future.
Lenders like to see that you’ve got more than enough income to meet your monthly obligations, and they evaluate this with a debt to income ratio.
What if you need to access the money? In some cases you can borrow against whatever you purchased. In the example above, you probably can’t dip into the $20,000 you invested in your home because lenders are hesitant to go above 80% loan to value. But if you initially put down more than 20% or you’ve been fortunate enough to enjoy price appreciation, you might pull some of that money out with a home equity loan.
A smaller down payment is nice for obvious reasons: you don’t have to come up with as much money. Saving 20% for a home purchase can take years. If you do happen to save a large amount, it’s scary to part with all that money – what if something comes up (your car breaks down, health problems arise, and so on)?
Putting all of your cash into a house or car means you’ve got all your money tied up in something that might be difficult to sell, and some people are uncomfortable with that.
Especially when it comes to a home purchase, small down payments are tempting. You can buy several years earlier, and you keep cash on hand for those inevitable improvements and repairs. But putting less than 20% down can cost you (at least temporarily – see below).
Finally, you’ll want to consider opportunity costs. 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.
It’s not uncommon for lenders to set a minimum required down payment (but of course 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.
Larger down payments might also have a psychological impact. They show that you have “skin in the game” – and you do. As a result, you’re more likely to keep making payments (walking away would be expensive). From a different perspective, a down payment shows lenders that you are willing and able to come up with a portion of the purchase price, so they’re more willing to approve loans.
What are some common requirements? With home purchases, 20% is an important number. Paying at least 20% allows you to avoid paying for private mortgage insurance (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 (but you’ll still pay for insurance, and you’ll want to evaluate whether or not you’re in a good position to buy).
For auto loans, lenders might require at least 10% down. However, some lenders are willing to allow up to 110% LTV (based on Kelley Blue Book values).
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, land can sometimes be used as a down payment when applying for a construction loan.