Down Payment: What Is It And How Does It Work?
Victoria Araj5-minute read
January 20, 2022
If you’re ready to put renting behind you and try your hand at buying a house, a great first step is to save for a down payment. But how much money do you need? How can you save for a down payment? Why do you need a down payment at all?
We’ve created a quick guide that will help you understand down payments, why they’re usually required and how much you should put down to buy a home.
Down Payment Definition
A down payment on a house is a large sum of money that the buyer pays upfront in a real estate transaction. The amount paid is usually a percentage of the purchase price and can range from as little as 3% to as much as 20% for a property being used as a primary residence.
The required down payment is usually determined by the type of mortgage you choose, but your financial situation and the type of property you’re buying (whether it’s your primary residence or an investment property, for example).
How Do Down Payments Work?
The amount you decide to pay for a down payment can dictate the terms for a few different aspects of your mortgage repayment process.
A larger down payment on a house, for instance, may get you into a more expensive property or a lower interest rate. However, there are also reasons you may want to put down less. Let’s look at how your down payment can affect the conditions of your loan.
Does Your Down Payment Affect Your Interest Rate?
The size of your down payment has a direct impact on the interest rate your mortgage lender will set for your loan. The larger the down payment you offer your lender, the lower your interest rate may be. A larger down payment generally means you’re a less risky borrower, and a less risky borrower means a lower interest rate.
A lower interest rate will help you save on your monthly payment and allow you to pay less interest over the life of the loan. On the other hand, if you decide to put down less money upfront, you might end up with a higher interest rate on your loan.
Does Your Down Payment Affect Your Monthly Mortgage Payments?
Just as it typically results in a lower interest rate, a larger down payment usually means smaller monthly payments. Since the balance of your loan is less, your monthly payments are smaller.
Let’s say you want to purchase a $300,000 home with a down payment of 10% ($30,000) on a 30-year mortgage. The balance of your loan would be $270,000, with payments divided between 360 months. Without considering interest, taxes or insurance, your monthly payment in this example would be about $750.
Now, let’s say that you put down 20% instead. This would lower the principal amount on your loan to $240,000. On a 30-year mortgage, your monthly payment would be about $667 (excluding interest, taxes or insurance).
Though you’d pay more upfront, the principal portion of your monthly payments would be about $83 less. That might not seem like much, but it’s also not the full picture. Using a 20% down payment to buy a house could save you hundreds of dollars a month on mortgage insurance, and it could also mean a better interest rate.
For a closer look at how your monthly payment can be affected by the size of your down payment, try a mortgage calculator. You'll enter some basic info to get an estimated monthly payment, and you can adjust down payment amounts to see what works best for you.
How To Decide On The Right Down Payment
Both large and small down payments have their own unique set of benefits. It’s important to weigh them carefully and take into account your own personal financial situation and goals before making a decision.
Benefits Of A Large Down Payment
Lower Rates And Premiums
Lenders love to see large down payments because it lowers the risk you pose to them. The larger your down payment, the less you have to pay each month in both principal and interest. Think of a down payment as an interest-free way to get a jump-start on paying off your home.
Avoid Mortgage Insurance
Certain types of loans require you to pay mortgage insurance. On a conventional loan, you generally need to put 20% down to avoid paying private mortgage insurance, which is usually a monthly fee that you pay as part of your monthly payment or is paid up front by the lender in exchange for a slightly higher interest rate. On an FHA loan, 20% down could be the difference between paying for mortgage insurance for the life of your loan and paying mortgage insurance for just the first 11 years.
Lower Debt-To-Income Ratio (DTI)
A lower DTI means you may have more borrowing power in the future. DTI represents how much of your monthly income goes toward paying off debt. A high DTI can prevent you from getting other loans or credit. (Most mortgage lenders look for a DTI of about 45% or lower.) If you’re looking to take on other loans or buy a second home, then borrowing less (by putting more down) could keep your DTI manageable.
Benefits Of A Small Down Payment
A 20% down payment can take years or even decades to save for, depending on your income. A lower down payment can help you own a home sooner.
Money For Repairs And Renovations
Emptying out your savings for your down payment might not help in the long run. As a new homeowner, you may find that you need more money for repairs and renovations than you thought. Setting aside this money upfront can make homeownership less stressful.
Keep An Emergency Fund
You won’t have to dip into your emergency fund. Keeping some money in the bank for emergencies is a smart move. You don’t want to have to pay for unexpected car repairs or medical bills on credit. Hanging onto some of your money could give you peace of mind and be a cheaper way to cover emergency costs.
Money For Other Ventures
Consider the opportunity cost of putting down more money on your home on the front end. Though you might be able to get a lower interest rate and monthly payment, it might make more sense for you to use that money for college tuition, investing or something else.
The Minimum Down Payment
You may have heard that you need a 20% down payment to buy a home. For many buyers, a 20% down payment isn’t realistic. Fortunately, 20% down is no longer the industry standard. The average down payment paid for a mortgage is about 6%.
Over the years, the industry has changed to make homeownership more accessible. It’s now possible to get a mortgage for as little as 3% down, although some loans (like VA loans and UDSA loans) require no money down.
Keep in mind that depending on your location, and your level of financial need, there may also be down payment assistance options worth looking into.
Why Lenders Typically Require A Down Payment
When your mortgage lender gives you a loan, they’re taking a risk on you. If you stop making mortgage payments, it’s possible that the lender won’t be able to make back the money they lent you.
A Down Payment Makes You Less Risky To Lend To
Putting money down helps mitigate risk for the lender in a couple of ways:
- It represents your investment in the home. If you were to stop making payments on the home, you’d be walking away from the thousands of dollars you put into it.
- It lowers the amount the lender has to give you for the purchase. If you’re paying 20% of the purchase price of the home, and they’re only lending you 80%, then that’s less money they’ll need to worry about getting back if you stop paying.
It’s important to note that the down payment requirement isn’t set by the lender alone. In many cases, the down payment requirement comes from the investor of the loan (which may be the Federal Housing Administration, Fannie Mae, the Department of Veterans Affairs or someone else).
The Bottom Line On Down Payments
Though a down payment is a crucial part of your home loan, it’s only a small piece of the overall financial picture. Knowing the down payment amount you’re comfortable with can help you search for homes that are within your budget and keep you from cutting too deeply into your emergency savings. To get approved for your mortgage so you can start house hunting, apply with Rocket Mortgage® now.
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