What Is A Down payment And How Does It Work?

Mortgage Dove

What Is A Down payment And How Does It Work?

Saving for a down payment is a significant first step if you want to move out of your apartment and into your own home.

Here's a quick guide to explaining a down payment, why you usually need one, and how much down payment you should save.


What Is A Down Payment?

When a buyer purchases an expensive item such as a car or a home, they usually make a down payment. The down payment represents a percentage of the total purchase price, and the balance is financed.

By making a down payment, the borrower can significantly reduce the amount they owe the lender, the amount of interest paid over the loan's life, and the monthly payments they must make.


How Do Down Payments Work?

Homebuyers commonly pay down payments when they purchase a home or car. The average first-time homebuyer pays 6% of their home's price for the down payment, then takes out a mortgage from a bank.

It's been standard in the U.S. for homebuyers to make a 20% down payment. A buyer's credit score, income level, and debt-to-income ratio can affect an interest rate, loan amount, and mortgage terms.

Fannie Mae and Freddie Mac set rules for conventional home loans in 2023 that require a minimum down payment of 3%. FHA loans for low-to-moderate-income families require a minimum down payment of 3.5%. Income limits typically accompany the lowest down payment requirements.

Example of a down payment

For example, if you plan to buy a $300,000 house and make a 10% down payment ($30,000) on the mortgage, you would need to finance the remainder with a home loan. Your monthly mortgage payment – excluding taxes and insurance – would be approximately $1,796 with a 30-year fixed-rate mortgage at 7% interest.

You would make $1,596 per month if you put down 20% on the $300,000 home, which is $60,000. You would qualify for the same 7% interest rate if you put down 20%.

Although the second scenario appears to be more expensive upfront, your monthly mortgage payments will be approximately $200 less in the second scenario.

In addition to saving hundreds of dollars a month, a 20% down payment can also reduce the amount of interest you pay on your loan because you won't have to pay mortgage insurance, your lender may offer a lower interest rate, and you'll be paying less interest on a more insufficient total loan balance. By making a 20% down payment, we would pay interest on a $240,000 loan rather than a $270,000 loan in our first example.

With a mortgage calculator, you can assess how your down payment size can affect your monthly mortgage payment. You will enter some basic information to get an estimate, and you can adjust the down payment amount to suit your needs.


Why A Large Down Payment Is Beneficial

A 20% down payment can provide several benefits in the long run. Here are some reasons why.

Rates and premiums are lower

When you make a large down payment, lenders are less likely to be concerned with their financial risk and more likely to be motivated. You pay less principal and interest monthly if you make a larger down payment. You can pay off your home interest-free by making a down payment.

Mortgage insurance is unnecessary

You typically need to put 20% down for conventional loans to avoid paying private mortgage insurance (PMI). PMI is normally paid upfront by the lender or added to your mortgage payment each month.

If you pay 10% down on your Federal Housing Administration (FHA) loan, you will not be required to pay mortgage insurance for the life of your loan.

Lower Debt-To-Income Ratio (DTI)

If you have a lower DTI, you have more borrowing power. The DTI measures how much of your monthly income goes to debt repayment, and most lenders want a DTI of around 43% or below. Suppose you want to apply for another loan or buy a second home. In that case, you can manage your DTI ratio by borrowing less and putting more down.


Why A Small Down Payment Makes More Sense

The national median home sales price of $431,000 makes saving 20% difficult, let alone saving for a down payment. First-time home buyers usually put 6% down on their homes, and about 22% received their money from a family member or friend, according to a survey conducted by the National Association of REALTORS® in 2022.

Let's look at some scenarios where a smaller down payment makes good financial sense.

Buying sooner is better

A lower down payment can help you own a home sooner. Saving up for a 20% down payment can take years or even decades.

Investing in repairs and renovations

It may not be wise to empty your savings for your down payment. You may need more money than you initially budgeted for repairs and renovations. Setting aside cash reserves upfront can make homeownership less stressful.

Maintaining an emergency fund

Keep some money in the bank for emergencies rather than using it all for a down payment. You won't have to rack up high-interest debt if you need an urgent car repair or medical bill. The best way to cover emergency expenses is to hang on to some money to offer peace of mind.

Investing in other ventures

Consider the opportunity cost when considering a larger down payment. While a larger down payment may result in a lower interest rate and monthly mortgage payment, it may be better to use it for college tuition, investments, or retirement planning.


Reasons Lenders Require Down Payments

The lender is investing in you when they give you a mortgage loan, but they also face a risk. Their risk is that the borrower may stop making mortgage payments, so they won't be able to recover the money they borrowed.

Down payments can reduce a lender's risk

The lender will be more confident that a borrower can repay the loan if money is down.

Keeping up with mortgage payments represents your investment in the property. If you stop paying, you'll walk away from the thousands of dollars you put into it.

You will have to repay less if you make a 20% down payment. If you make a 20% down payment, you can borrow 80% of the purchase price.

The lender doesn't necessarily determine a down payment requirement. Sometimes, it's determined by the entity backing the loan, such as the Federal Housing Administration (FHA), Fannie Mae, or the Department of Veterans Affairs.


Frequently Asked Questions About Down Payments for Mortgages

Here are a few frequently asked questions about down payments.

Is your interest rate affected by your down payment?

If you make a larger down payment, your interest rate will be lower. If you make a smaller down payment, your interest rate may be higher.

Even though a lower interest rate may allow you to save money throughout the loan, it may result in a higher interest rate if you put down less money upfront.

Are your monthly mortgage payments affected by your down payment?

Because you have a smaller loan balance, your monthly mortgage payments are usually lower if you make a larger down payment.

How much down payment is required for a mortgage?

To buy a house, you must make a 20% down payment. However, for many buyers, 20% down can be unrealistic. Fortunately, 20% down is not required for a primary residence. The average amount for a down payment is 6%.

With the changes in the industry, homeownership has become more accessible. Today, you can get a mortgage with just 3% down, and VA and USDA loans do not require a down payment.

Is there a down payment assistance program?

The down payment is one of the biggest hurdles to homeownership. However, you may be eligible for down payment assistance depending on where you live and your financial situation. You should check the requirements for programs that interest you since some are only available to first-time homebuyers.


Bottom Line

Regarding home loans, down payments are essential to your overall financial picture. Knowing how much you can afford to put down can help you find a home within your budget and avoid draining your savings.

"Mortgage Dove makes home financing convenient for every American. You can count on us to provide a home buying experience tailored to your personal needs and financial situation. We strive to give you the peace of mind that your home financing goals can be achieved.”


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