If you’re buying a home, odds are you don’t have hundreds of thousands of dollars lying around to foot the bill. You’ll need financing to make this dream a reality.
Unfortunately, lenders won’t just hand over wads of cash and call it good.
They want to know you’re good for it — even if it takes 30 years to get their money back. A down payment is one way to reassure your lender that you not only have the means but also the responsibility to pay back the money you owe.
And if you think that a down payment will only affect you when you are buying a home, think again. Down payments are required for a variety of different types of loans.
Discover how a down payment works, the pros — and cons of making a large down payment, and why down payments are a crucial aspect of the home buying process.
What’s Ahead:
What is a down payment?
A down payment is the sum of money you pay up-front and out-of-pocket for a large purchase, such as a home or car. It is a portion of your total purchase price, typically between 3% and 20%, the remainder of which you cover through financing.
The type of loan you select, as well as your own financial history, will help determine how large of a down payment you’ll need to qualify for your loan.
Generally, the more money a borrower puts down, the smaller a risk they pose to lenders. As a result, the size of your down payment can affect details like your interest rate, which in turn impacts the amount of money you owe both monthly and over the life of your loan.
How a down payment works
For most major purchases, but not all, a down payment is necessary to qualify.
Many lenders require a minimum down payment — such as 5%. You’ll typically pay with a check, money order, or wire transfer; although, for some loans, you can even use an asset like land for your down payment.
Your down payment will depend on the loan type
The type of financing you pursue helps inform how big your down payment should be. In fact, some loans, like VA or USDA home loans, do not require a down payment at all.
However, borrowers can, and in many cases should, contribute more towards the loan principal if they have the means. This is because, in most cases, paying extra towards your loan principal can help you save on interest.
A larger down payment = better loan terms
A larger down payment indicates less risk for lenders, so a lender may offer you better loan terms, such as a lower interest rate, if you put more money down.
Additionally, if you put down 20% or more towards a home loan, you may avoid the added expense of private mortgage insurance (PMI), which lenders use to offset risk.
With all this said, bigger isn’t always better. Putting down too large of a down payment may hinder your ability to cover future expenses, so it’s important to think through the pros and cons of both large and small down payments before you write the check.
What is a common down payment on a home?
20% of your total purchase price is a common down payment size for a home, and decades ago, 20% was certainly attainable for many first-time home buyers. Today, however, this is far from the norm.
According to data from reputable sources like the National Association of Realtors and Attom Data Solutions, the average down payment for first-time homebuyers is actually closer to 6%. Repeat buyers managed to get a little closer to the 20% target, putting down a median of 16%.
Down payments for auto loans have a similar history. According to Kelley Blue Book, 20% down is no longer necessary to qualify for an auto loan, and in fact, only half that is required.
How the type of financing impacts your down payment
The type of loan you pursue is the first indicator of how large, or small, your down payment needs to be.
Conventional loans are a particularly common type of mortgage loan in America, and most lenders require a minimum of 5% down to qualify. However, the borrower’s background also plays a crucial role. For instance, if your credit score is lower than 620 or you’re already steeped in debt, it’ll be harder to convince a lender you’re worth the risk.
For borrowers who can’t quite meet conventional loan qualifications, FHA loans may be an ideal solution, which requires just 3.5% down and a credit score of 580.
Then again, there are still some financing options that don’t require a down payment at all, specifically government-backed options like VA and USDA loans.
How to determine the size of your down payment
Before you assume 6% or even 20% is a reasonable down payment target, think about how that number will affect your future finances.
The size of your down payment impacts how much you’ll owe every month, so settling for the minimum may not be your best course of action if it means you’ll have a larger premium. Then again, too large of a down payment may prevent you from paying for planned and unplanned costs down the road, like a beach vacation or a broken refrigerator.
Is a bigger down payment better?
Although there are certainly benefits to a larger down payment, whether or not that route is right for you depends on several factors, including your financial history and future goals. In fact, there are plenty of perks to consider for small down payments as well. These include:
- You can buy sooner. Let’s say you want to buy a home for $275,000. If you planned to save 20% for a down payment, you’d need to set aside $55,000. However, if you aimed for a 6% down payment, you’d only need $16,500. Both goals require plenty of time and patience, but the 6% target is far more practical for those who want to begin house hunting sooner rather than later.
- You can save for unexpected expenses. Buying a home or car is certainly a large expense, but it won’t be the only one. If you cobble together $25,000 for a down payment on a house, then experience a car accident the following month, would you have enough savings to cover the damages? Find a balance between the size of your down payment and a healthy emergency fund.
- You can save for future purchases. In addition to the unexpected expenses, think through your future financial goals before you put money down for a home or car. Are you saving for your child’s college tuition? Do you dream of remodeling your 1970s kitchen?
Summary
The right size for your down payment is dependent on a number of factors, from the type of financing you choose to your financial history and future plans.
Before you assume you’ll need 20% down to afford your new home or car, evaluate details like industry norms as well as your own financial goals.
Read more:
About the author
