Purpose of a down payment: Making an initial investment for your house
Down payments are an initial investment made towards 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 mortgage loan, creating a lien on the property, which is held by the lender.
Most mortgage loans will 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 size of a down payment can vary depending on the type of mortgage. While this payment is usually 20% of the sales price for a typical mortgage, 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 see the 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 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 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 make 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 the amount of interest paid of time is less.
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 does it establish ownership, but down payments factor heavily into the amount loaned for a mortgage and the interest that will be paid over time.