What is a Down Payment?
Summary
A down payment is an upfront cost you pay when financing a major purchase like a home or car. Learn how a down payment works, how much you might need and how it can impact your loan.
In this article:
If you want to buy a house with a mortgage or a car with an auto loan, you may wonder what you need to do to get approved. In many cases, your lender may require a down payment. The amount of your down payment as well as other factors like your credit score and the purchase price could determine both how much money you could get approved for as well as how much you pay over the life of the loan.
Let’s go over what a down payment is as well as how it works and strategies to help you save for one.
What is a down payment?
A down payment is an upfront cost you pay when seeking to finance a major purchase, like a house or car, with a loan. In most cases, a down payment is a percentage of the purchase price. For example, if you're buying a $25,000 car and make a 10% down payment, you’d pay $2,500 upfront and finance the remaining $22,500 with a loan that you would repay in monthly installments plus interest.
How does a down payment work?
A down payment works by reducing the amount you need to borrow from a lender, which could also lower your monthly payments and interest over the life of the loan compared to borrowing the full amount of the purchase price. In some cases, a higher down payment may even help you avoid additional costs like mortgage insurance when purchasing a home.
Once you’ve agreed on a purchase price, you’ll provide the down payment upfront — usually at closing for a home or when finalizing the deal on a car. If you are purchasing a house, you will typically give the down payment to the lender. When purchasing a car, you’ll typically provide the down payment directly to the dealer and then finance the remaining amount with the lender. Payment options may vary but are usually requested in the form of a check, debit or electronic transfer, depending on the type of purchase.
The down payment amount goes directly toward the total cost of the purchase, and the remaining balance is financed through a loan. The lender then structures your loan based on that reduced amount.
How much of a down payment do you typically need?
A number of factors, such as the lender’s requirements, loan type and your credit score, could determine how much of a down payment you may need or if one is even required.
Auto loan
Lenders typically require a down payment of about 10% for a used car and 20% for a new car,1 but this amount could be more or less depending on your credit score. You may also have the option to negotiate paying a lower down payment in exchange for a higher interest rate. Keep in mind that a higher interest rate could mean you’ll pay more in interest over the life of the loan, which could result in a greater overall cost for the vehicle.
Mortgage
The amount you would need to put down on a home depends on the type of loan you’re using and the qualifications you meet, such as your income, debt-to-income (DTI) ratio and overall credit history. Below are some of the most common types of home loans and their typical down payment requirements:
- Conventional mortgage loan: Often used by borrowers with stronger credit scores, these loans are provided by banks, credit unions and traditional lenders like mortgage companies and usually require at least 3% down.2
- Federal Housing Administration (FHA) loan: Backed by the FHA, this loan is most common with first-time buyers and requires a minimum down payment of 3.5% for people who meet certain credit and income qualifications.3
- Veterans Affairs (VA) loan: Available to eligible veterans, active-duty service members and some military spouses, this loan is backed by the Department of Veterans Affairs and typically requires no down payment.4
- U.S. Department of Agriculture (USDA) loan: Designed for rural and some suburban homebuyers with low to moderate incomes, this government-backed loan also requires no down payment if you meet the eligibility criteria.5
How does a down payment affect your loan?
The amount you choose to put down could affect the following aspects of your loan:
- Loan amount: With a larger down payment, you’ll reduce your total loan amount and likely pay less in interest. Depending on your situation, this may lead to significant savings over the life of your loan.
- Loan-to-value (LTV) ratio: The LTV ratio refers to the amount you’re financing compared to the appraised value of the house, car or other asset you’re buying. The more you put down, the lower the ratio, which may potentially help you get approved for a loan with favorable rates and terms. A lower LTV ratio may also eliminate the need for mortgage insurance.6
- Interest rate and approval odds: A higher down payment reduces the amount of money you need to borrow as well as a lender’s risk. For this reason, a down payment may increase your chances of getting approved for a loan with a competitive interest rate.7
- Private mortgage insurance: In general, you’ll need to pay PMI if you take out a conventional mortgage and put less than 20% down. However, you can avoid PMI with a down payment of at least 20%.
Tips for saving for a down payment
If you plan to finance a house, car or any other expensive asset, these tips could help you boost your savings for the down payment:8
- Set a goal and stick to a timeline: Think about how much you’ll need to save for your down payment and when you hope to achieve this goal. Getting specific can help you plan to save regularly for your financial goals.
- Automate your savings: You could schedule regular automatic deposits from your checking into your savings account so you can save for your down payment without thinking about it. You could also look into having a portion of your paycheck automatically deposited into your savings account through your bank or your employer.
- Use windfalls: Windfalls such as tax refunds, bonuses or birthday gifts can grow your down payment fund. It may be a good idea to deposit this money into a high-yield savings account (HYSA) that offers a higher interest rate than a traditional bank account, but keep in mind that you might have to meet a minimum amount to open this kind of account.
- Explore down payment assistance programs: If you’re planning to purchase a home, you can search for down payment assistance programs in the form of grants or low-interest loans. Typically offered at a state or local level, these types of programs are often reserved for first-time homebuyers who meet certain criteria.
What you pay upfront pays off later
The size of a down payment could significantly impact your finances in the long run. Committing to a higher down payment up front might increase your chances of loan approval and help you lock in a lower interest rate. With a lower interest rate, you may enjoy smaller monthly payments and reduce the amount you spend on interest over the life of your loan.
If you’re proactive about planning ahead and saving for a down payment now before you buy a house, car or other big-ticket item, your future self (and bank account) might thank you.
Sources
1 https://www.nerdwallet.com/article/loans/auto-loans/how-much-down-payment-make-buying-car
2,3,4,5 https://www.bankrate.com/mortgages/how-much-is-a-down-payment-on-a-house/#down-payment
6 https://www.experian.com/blogs/ask-experian/what-is-loan-to-value-ratio-and-why-is-it-important/
7 https://www.bankrate.com/mortgages/what-is-down-payment/
8 https://www.investopedia.com/articles/investing/092815/where-should-i-keep-my-down-payment-savings.asp#toc-5-develop-a-savings-plan
This article is for general education and informational purposes, without any express or implied warranty of any kind, including warranties of accuracy, completeness, or fitness for any purpose and is not intended to be and does not constitute financial, legal, tax, or any other advice. Parties (other than sponsored partners of OneMain Financial (OMF)) referenced in the article are not sponsors of, do not endorse, and are not otherwise affiliated with OMF.
