What is a down payment and how does it work?

One of the first steps on your home buying journey is saving up for a down payment. How much you need to save can depend on certain factors. There are also benefits to making a larger down payment versus a smaller one, and vice versa. Use our guide below to understand what a down payment is, why you usually need to save for one and how much you should put down to buy a home.

What is a down payment on a home?

A down payment on a house is the money a buyer pays upfront to complete the real estate transaction. Down payments are typically a percentage of a home’s purchase price and can range from 3% – 20% for a primary residence.

The required down payment is usually determined by the type of mortgage you choose, your financial situation and the type of property you’re buying (a primary residence or an investment property, for example).

How do down payments work?

The amount you put toward a down payment can influence the loan amount you qualify for and the terms of your mortgage repayment. Putting money down on a house also helps lower your total loan amount. The less money you borrow, the more money you save on interest over the life of the loan.

A larger down payment may also help you purchase a higher-priced home or get a lower interest rate, but first-time home buyers may have trouble saving up that much money. There are also reasons to put down less on a house, which we’ll get into later.

Your mortgage down payment is made at closing, though it’s separate from your closing costs. The down payment funds are held in escrow until the sale is complete, at which point they’re disbursed to the seller.

Why lenders typically require a down payment

When your mortgage lender gives you a loan, they’re investing in you. As you likely know, all investments come with some degree of risk. A lender’s risk is that a borrower may stop making mortgage payments, and they won’t recover the money they loaned.

Here are some ways putting money down can help a lender feel more confident about a borrower’s ability to repay their home loan:

• It represents your investment in the home. If you stop making mortgage payments, you’ll be walking away from the thousands of dollars you invested in the property with your down payment.
• It lowers the mortgage loan amount. If you make a down payment that’s 20% of the home’s purchase price, the lender only has to lend you 80% of the purchase price. That’s less money they’ll be entrusting you to repay.

It’s important to note that down payment requirements aren’t solely determined by lenders. In many cases, the down payment requirement is set by the entity backing the loan, which may be the Federal Housing Administration (FHA), Fannie Mae, Freddie Mac or the Department of Veterans Affairs (VA).

Minimum mortgage down payment requirements

You may have heard you need to make a 20% down payment to buy a home. But for many buyers, a 20% down payment can be unrealistic. Fortunately, 20% down isn’t a requirement for a primary residence. The amount you need for a down payment will usually depend on what type of mortgage you’re getting.

Over the years, the industry has changed to make homeownership more accessible. Today, you can get a mortgage for as little as 3% down. Some loans, like VA loans and U.S. Department of Agriculture (USDA) loans, require no money down.

Here are the minimum down payment requirements by loan type:

Use a mortgage calculator to see how your monthly mortgage payment can be affected by the size of your down payment. You'll enter some basic information to get an estimated monthly payment, and you can adjust down payment amounts to see what may work best for you.

Benefits of a larger down payment

There are several benefits to putting down a 20% down payment. Let’s explore why a 20% down payment or higher can help you in the long run.

Lower interest rates

The size of your down payment has a direct impact on the interest rate your mortgage lender sets. The larger the down payment, the lower your interest rate may be.

As we’ve discussed, lenders appreciate large down payments because it lowers their financial risk and shows that you’re a motivated buyer. The lower interest rate you may get with a larger down payment can help you save money by paying less interest over the life of the loan. If you put down less money up front, you may end up with a higher interest rate.

Smaller monthly payments

A larger down payment usually means smaller monthly mortgage payments. Since your loan balance is smaller, your monthly mortgage payments are smaller. Having a lower interest rate will also help keep your monthly payments on the smaller end.

Potential to avoid mortgage insurance

You generally need to put 20% down to avoid paying private mortgage insurance (PMI) on a conventional loan. PMI is typically a monthly fee that gets added to your monthly mortgage payment or is paid up front by the lender in exchange for a slightly higher interest rate.

On an FHA loan, 10% down can be the difference between paying mortgage insurance for the life of your loan or for the first 11 years.

Instant equity in your home

Since your home’s equity is the difference between your home’s value and your remaining mortgage balance, a larger down payment can instantly give you 20% equity. You can tap into this equity to borrow cash through a home equity loan or cash-out refinance.

Reasons to make a smaller down payment

According to a 2023 National Association of REALTORS^® survey, first-time home buyers typically put 8% down on their homes.

Let’s explore some scenarios where it may make financial sense to make a smaller down payment.

Buy a home sooner

It can take years to save for a house, and even decades to save up for a 20% down payment. A lower down payment can help you own a home sooner. Depending on the current housing market, it could be more beneficial to look into buying sooner than later.

Save money for repairs, renovations and other expenses

Emptying out your savings account for your down payment may not be the best financial decision in the long run. You may need more money for repairs and renovations than you originally budgeted for. You may also want to have funds available to pay for moving costs, utilities, appliances and household decor.

Setting aside cash reserves, or creating an emergency fund, can make homeownership less stressful.

Afford closing costs

As we mentioned, your down payment is a separate expense from your mortgage’s closing costs. Average closing costs can equal 3% – 6% of your whole loan amount and are due at closing. If making a larger down payment means you’d struggle to afford these costs, then you’d be better off putting down a smaller percentage up front.

Set aside money for other ventures

Factor in the opportunity cost when considering putting down more money upfront. Though a larger down payment may earn you a lower interest rate and monthly mortgage payment, it may make more sense to use the money for college tuition, investments or retirement.

The bottom line

Knowing the down payment amount you’re comfortable with can help you search for homes in your budget and keep you from draining your savings. How much you’ll need to put down can depend on what type of loan you apply for, but you also need to think about what else you could put some of that money toward. There are benefits to making a large down payment or a small one, so consider what you want out of homeownership before you make the choice.

If you’re ready to finance your home buying dreams, get started today with Rocket Mortgage^®.