Purpose of a down payment: Making an initial investment for your house
When you take out a mortgage, your lender will cover most of the home’s sales price, but a portion of that expense will have to be covered by you upfront.
Down payments are an initial investment made toward a large purchase that establishes ownership of an asset. In real estate purchases, the size of a down payment is usually within 5% and 25% of the property’s sales price and is provided by the homebuyer.
The remainder of the sales price is covered by the lender, who places a lien on the property for the duration of the loan.
Most mortgages require a down payment, which is calculated as a percentage of the home’s total price. The lender then loans the remaining balance of the sale. For example, a 20% down payment on a $200,000 home would be $40,000. The lender then lends the 80% difference, or $160,000.
Determining the size of a down payment
The average down payment in the U.S. is about 6% of the total loan. However, the size of a down payment can vary depending on the type of mortgage. While most homeowners hear that 20% is common for a down payment, a down payment for an FHA loan is much lower. VA loan applicants may not require a down payment at all.
A borrower’s credit score can also impact the amount needed for a down payment. A lower credit score indicates to lenders that the borrower might not have a great history of handling debt, and could be at risk of missing mortgage payments. A larger down payment decreases the amount the bank will need to provide for a loan and lessens the lender’s risk in using the property as collateral. If a borrower with a low credit score defaults on their loan, the bank can more easily recoup their losses.
Generally, lenders are more likely to approve loans when the buyer makes a larger initial investment in the property. Lower down payments mean a larger risk for the lending organization, so applicants who can make a larger initial investment in their property are more likely to have their loan approved.
If a borrower is unable to put up a suitable amount for a down payment, the lender can require them to purchase private mortgage insurance.
Down payments and mortgage types
Here’s a look at some different types of mortgages and how down payment requirements can vary:
- VA loans
- FHA loans
- USDA loans
VA loans
VA loans provide a path to homeownership for military members and their families. In addition to the many benefits associated with this type of financing, VA loans have no down payment requirement.
In a conventional loan scenario, perhaps for a 30-year fixed-rate mortgage, borrowers will have spent years saving for this expense alone. Bypassing the down payment can help streamline the mortgage process and get you into your new home sooner. By avoiding the expense entirely, you’ll also be able to explore buying options in a wider price range with greater flexibility.
When the housing market gets competitive, an offer that comes with a zero down payment could also appeal to sellers. Zero down payment requirements eliminate the possibility that the buyer can’t afford the expense and the sale won't go through. In addition to the security of government backing, sellers might be more eager to accept a VA offer by avoiding this financial barrier altogether.
FHA loans
If you don't have the credit or savings on hand to afford a typical financing plan, FHA loans might be your best bet.
These government-insured loans allow lenders to approve financing with more lenient terms. As housing prices continue to rise, borrowers paying off their student loan debt or auto loans might not have the financial bandwidth for a sizable down payment, which is why many hopeful borrowers apply for FHA loans.
Depending on your credit score, your FHA down payment requirement can vary. Applicants with a credit score of 580 or higher are usually able to qualify for a 3.5% down payment option. Scores in the 500-570 range may require a minimum 10% down payment on the home, according to Investopedia.
USDA loans
USDA home loans provide financing options for low to moderate-income individuals and families to promote homeownership in rural communities.
Depending on your income, credit score and location of the property, these mortgages can come with a zero down payment requirement. Qualifying applicants will also benefit from competitive mortgage rates on USDA mortgages.
Down payments and private mortgage insurance
Lenders who agree to lower down payments may also require the buyer to carry private mortgage insurance, or PMI. Although PMI is purchased by the homebuyer, these insurance premiums are made to benefit the lender in the event of a default on the lien on the property.
Mortgage insurance is usually a prerequisite for loans where the buyer’s down payment is less than 20%. The insurance company will cover a portion of the home’s value, reducing any loan loss if the property is foreclosed upon.
Private mortgage insurance provides a path to homeownership for individuals who are unable to contribute 20% or more for a down payment. While this lowers the amount a borrower will need to invest upfront, monthly premiums for private mortgage insurance will be folded into their monthly mortgage payments.
Can down payments impact interest rates?
A larger down payment not only increases a borrower’s chance of mortgage approval, but can also reduce the amount that a borrower will pay in interest over time.
If a borrower can make a larger down payment for a home, the lender will extend a smaller loan, which carries less risk. This lowers the amount of the initial loan and greatly limits the amount of interest that will be paid throughout the life of the mortgage.
Making a larger down payment means the borrower has a larger equity stake in the property and the lender finances a smaller mortgage against the property value. Therefore, borrowers who are able to provide larger than required down payments will have a better chance of getting their mortgage application approved.
This reduces the lender’s risk associated with providing the mortgage, and borrowers pay less interest over time.
In conclusion
Down payments allow borrowers to become homeowners once they find an option that fits, making it an essential piece of the mortgage process.
Not only do they establish ownership, but down payments factor heavily into the amount lended for a mortgage and the interest that will be paid over time.