What is a down payment?

Mortgage 101
Understanding what a down payment is, how it affects your interest rate, and the different requirements will help you decide what is best when the time comes to buy a home.
Published on
July 27, 2023
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Once you decide to buy a home, there are a range of different payments that you'll want to keep in mind to make sure that you have enough savings in your bank account. Even though the mortgage loan you obtain should take care of most of your expenses, you're still expected to put some of your money towards closing costs as well as a down payment. If you've purchased a home before, the down payment that you make dictates what your interest rate will be as well as how much you'll pay on your monthly mortgage bills. This guide offers an in-depth rundown on down payments and what they mean when buying a home.

What Is a Down Payment

The down payment that you'll need to make before you can be approved for a loan refers to the amount of the home's purchase price that you decide to pay upfront. This payment must come from your own money and is not covered by the loan that you obtain. Many mortgage lenders will use a loan-to-value ratio when determining how large of a loan they will provide. If you put down $4,000 on a $100,000 home, your loan-to-value ratio will be 96%.

If you're wondering why you should make a sizable down payment, it's important to understand that there are many benefits for doing so. Along with a reduced interest rate, you may be able to avoid paying for private mortgage insurance. Most lenders have set minimum requirements for down payments, which means that you will likely need to pay at least some money as a down payment before your loan application will be approved.

How Do Down Payments Work?

Down payments are relatively simple and straightforward. Let's say that you're purchasing a $300,000 home and have made the decision to pay $30,000 for your down payment. By doing so, you would be making a down payment of 10%, which is relatively high. While the preferred down payment amount is 20% or higher, making a down payment of 10% will allow you to obtain a somewhat lower interest rate when compared to someone who only makes a down payment of 3.5%.

Once you've made a down payment of $30,000 on a $300,000 home, you will likely need to take out a mortgage for the remainder of the costs, which means that the loan amount would need to be around $270,000. A higher down payment always results in a lower loan amount, which will lead to reduced monthly mortgage payments as well as lower interest on your loan. The benefits of making a high down payment are extensive, which is why it's highly recommended that you save until you can make a sizable down payment.

How a Down Payment Affects Your Interest Rate?

The down payment that you make will directly affect the interest rate you receive from your lender. Borrowers who make high down payments will receive more favorable terms than ones who don't. By paying more money upfront, your lender will invariably find the prospect of loaning money to you less risky, which is why they will likely provide you with a lower interest rate.

If the lender must pay for nearly all of the home, they might feel as though the borrower is unable to afford the home, which makes it a riskier proposition for them. If you're able to obtain a reduced interest rate by making a high down payment, you'll find that your monthly mortgage payment will be reduced as well. Keep in mind that you will also need to set aside a significant amount of money to pay for closing costs.

What to Consider When Deciding on a Down Payment Amount

When you're trying to determine what your down payment should be, there are numerous factors that you should take into account. First of all, it's important to better understand how a large or small down payment benefits you as a prospective homeowner. While there are numerous benefits associated with making a large down payment, there are also several advantages of making a smaller and more reasonable down payment. The option that's best for you depends on your current situation and how much savings you have.

The credit score you currently have can also play a part in how much a high down payment benefits you. If you have a low credit score, making a higher down payment may help you obtain a mortgage at more favorable rates. It's possible that making a high down payment is the only way for you to obtain a mortgage depending on how low your credit score currently is. In the event that your credit score is high, you may be allowed to put down a relatively low down payment without incurring a high interest rate from your lender.

Do You Need PMI?

Private mortgage insurance is a type of insurance that many lenders require for conventional loans as well as FHA loans, the latter of which are government-backed loans provided by the U.S. Federal Housing Administration. When you're searching for the right home, you may hear that a 20% down payment is the ideal amount. The reason that many real estate agents and lenders recommend making a high down payment of 20% is because doing so allows you to avoid paying for PMI.

If you happen to make a down payment of $50,000 on a $300,000 home, you will still be required to obtain private mortgage insurance before you can receive your loan. The reason that PMI is still necessary is because $50,000 is around 16.66% of $300,000. While this down payment amount can help you receive a reduced interest rate on your loan, private mortgage insurance will still be required. Keep in mind that you only need to hold onto this insurance until you've built up 20% equity in your home, which won't take long if you make a 16% down payment.

Having Money in Reserve for Upgrades or Repairs

If you're thinking about making a high down payment to obtain a lower interest rate or to avoid paying for private mortgage insurance, you should still have a certain amount of money in reserve for any unexpected upgrades or repairs that you may need to make.

Buying a home is rarely ever straightforward. Imagine that you've purchased a relatively modern home for $250,000. The inspection that was held during the closing process may tell you that all appliances are in good working condition and that the structure of your home is sound. However, this doesn't guarantee that a major appliance won't malfunction and break down a week after you've moved in.

Even new and modern appliances can malfunction without any forewarning, which is something that you should take into account before completing the process of buying a new home. If a major repair or replacement needs to be made, you may be tasked with spending thousands of dollars immediately after you've moved in.

In the event that you don't save put some money in reserve for upgrades or repairs, you might find it difficult to make your payments on time. You can mitigate this risk by putting aside some money for unexpected costs. However, doing so might mean that you will need to lessen the amount you pay for your down payment.

Minimum Down Payment Requirements

The minimum down payment requirements differ with each type of mortgage that you can apply for. It's possible that the sale price of the property could also determine what the minimum down payment is. You'll find that minimum down payment requirements can range from 0-20%. The minimum requirements for down payments can be separated into conventional loan requirements, government-backed loan requirements, and jumbo loan requirements.

Conventional Loan Requirements

Freddie Mac and Fannie Mae are two national mortgage associations that purchase loans directly from mortgage lenders, which helps to accommodate lower down payment requirements in comparison to other mortgage types. Because of the lower down payment requirements, you will need to purchase private mortgage insurance if your down payment is less than 20%. This requirement is primarily limited to conventional loans.

If you're purchasing a single-family home, a conventional loan provides you with the opportunity of borrowing as much as 97% of the property's purchase price, which means that the minimum down payment requirement is just 3%. Keep in mind, however, that lower down payments lead to higher monthly mortgage payments and interest rates. Some property types will come with minimum down payment requirements of 5%. These properties include condominiums and duplexes.

Government-Backed Loan Requirements

Government-backed loans can be obtained even if you don't provide a high down payment. The minimum down payment requirements for a government-backed loan depend on the type of loan you're seeking. For instance, you must pay at least 3.5% of the home's sale price when applying for an FHA loan.

Borrowers who have credit scores between 500-579 will be tasked with providing a down payment of at least 10%. As for VA and USDA loans, eligible borrowers may be able to receive these loans with no down payment, which means that the loan-to-value ratio would be 100%.

Keep in mind that insurance may be required when you apply for a government-backed loan. If you seek an FHA loan, the insurance is referred to as mortgage insurance premiums. These premiums are initially paid upfront with follow-up payments being required on an annual basis. USDA loans and VA loans come with similar requirements. These forms of insurance are designed to provide the lender with a certain level of protection in the event that a borrower defaults on the loan.

Jumbo Loan Requirements

Jumbo loans come with unique down payment requirements because of what these loans are used for. A jumbo loan is designed to provide borrowers with the ability to purchase a high-priced home. Any loan is considered to be a jumbo loan if it goes higher than the amount of money that Freddie Mac and Fannie Mae will back when purchasing a mortgage. At the moment, these two mortgage associations will purchase loans that are priced at $548,250 or less.

If you decide to put down $100,000 on a $700,000 home, the remaining $600,000 will need to be provided to you in a jumbo loan. These loans are considered to be risky because of how much money is being lent to a single person. As such, the loan requirements are higher. To receive a jumbo loan, you must make a down payment of 10% or higher. Keep in mind that certain lenders may ask for down payments of at least 20%.

Unless you can pay for the entire sale price of a home in cash, you will likely be required to make a down payment before you can receive a loan for the remaining costs. There are numerous factors to consider when you're trying to determine what your down payment should be. If you want to avoid private mortgage insurance and would like to obtain a low interest rate, paying 20% or more may be beneficial. On the other hand, a lower down payment would allow you to place more of your money into emergency savings. Make sure that you weigh the pros and cons of each option before making this decision.

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