What Is a Down Payment?
A down payment is a sum a buyer pays upfront when purchasing an expensive good such as a home or car. It represents a percentage of the total purchase price, and the balance is usually financed. A down payment can significantly reduce the amount the borrower owes to the lender, the amount of interest they will pay over the life of the loan, and monthly payment amounts.
Key Takeaways:
- A down payment is paid upfront in a financial transaction, such as purchasing a home or car.
- Buyers often take out loans to finance the remainder of the purchase price.
- The higher the down payment, the less the buyer will need to borrow to complete the transaction and reduce the interest paid over the long term.
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How Down Payments Work
Buyers commonly pay a down payment when purchasing a home or car. The average first-time home buyer pays 6% of the home price as their down payment and takes out a mortgage from a bank or other financial institution for the remainder.
For car purchases, it is common to pay a down payment of at least 20% of a new car's price. Because the value of a car depreciates quickly, a high down payment ensures buyers do not owe more than the car is worth after a year or two.Like mortgages, car loans often carry interest, and a down payment reduces the interest paid over the life of the loan.
Types of Down Payments
Home Purchases
In the United States, a 20% down payment on a home has been the standard. Because a buyer's credit score, income level, and debt-to-income ratio help determine a loan's interest rate, borrowed amount, and terms of the mortgage, a larger down payment can be beneficial.
For 2023, the minimum down payment is 3% for conventional home loans per rules set by government-sponsored entities Fannie Mae and Freddie Mac. For FHA loans that help low- to moderate-income families attain homeownership, the minimum down payment is 3.5%. The lowest down payment requirements commonly carry income limits.
Important
Upfront fees on Fannie Mae and Freddie Mac home loans changed in May 2023. Fees were increased for homebuyers with higher credit scores, such as 740 or higher, while they were decreased for homebuyers with lower credit scores, such as those below 640. Another change: Your down payment will influence what your fee is. The higher your down payment, the lower your fees, though it will still depend on your credit score. Fannie Mae provides the Loan-Level Price Adjustments on its website.
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Auto Purchases
For car purchases, a down payment of 20% or more can make it easier for a buyer to be approved for a loan and get a better interest rate and other terms. Car dealers may also offer promotional terms of 0% down for buyers who qualify. While that means no down payment is necessary, the lender may charge a higher interest rate.
A down payment of 20% or more may get you a lower interest rate on an auto loan.
Benefits of a Large Down Payment
A significant down payment decreases the amount of interest paid over the life of the loan and lowers monthly payments.
- Interest: A $100,000 loan with a 5% interest rate means $5,000 in interest in the first year. However, with a $20,000 down payment and a loan of only $80,000, first-year interest will be just $4,000. For a 30-year mortgage loan, borrowing $100,000 at 5% interest costs $93,256 in interest. Borrowing just $80,000 saves nearly $20,000, with a total interest cost of $74,605.
- Monthly Payments: A larger down payment reduces monthly payments. A $100,000 loan at 5% interest carries monthly payments of $537, while an $80,000 loan has a payment of $429.
- Mortgage Insurance: Private Mortgage Insurance (PMI) is usually required when you have aconventional loanand make a down payment of less than 20 percent of the home’s purchase price. PMI serves to protect the lender if the buyer stops making payments on the loan.Borrowers can request the lender drop the PMI requirement once the equity in the home reaches 20%.
Paying Off a Loan
Homeowners unable to put down a large down payment can plan to make additional payments toward their mortgage principal each month, reducing the loan amount and interest over time. This is often referred to as making accelerated payments or accelerated amortization. Buyers may choose to refinance their mortgage if their finances improve and make a larger down payment on the new loan.
Is a Down Payment the Same as a Deposit?
In most cases, yes. Down payment and deposit are often used interchangeably. Both terms refer to the same process of providing an upfront payment as a percentage of a total sale.
Why Is It Important to Have a Down Payment?
A down payment will reduce the loan amount, interest cost, and monthly payments. The amount of the down payment may also reduce the interest rate provided by the lender.
Why Do Lenders Require Down Payments?
Downpayments reduce the risk for lenders. Not only do they reduce the amount of money that needs to be lent out; by acting as the "cost of entry" for a loan, but a downpayment can also be used to prove that the borrower is serious about a loan.
The Bottom Line
A down payment is a sum a buyer pays upfront when purchasing a home or car and is a percentage of the total purchase price. The higher the down payment, the less the buyer will need to borrow to complete the transaction, the lower their monthly payments, and the less they'll pay in interest over the long term.
