With the U.S. home price averaging around $350,000 (depending on where you live), coming up with a hefty down payment may seem impossible to the average consumer. However, finding a way to come up with at least 20 percent as a down payment may be the most significant gift you can give yourself in the home-buying process.
The same can be said when buying a car or truck. As a general rule of thumb, it is recommended that you make a down payment of at least 20% of the car's purchase price. This can help you secure a better interest rate, lower your monthly payments, and reduce the overall cost of the loan. So, if your vehicle of choice is priced at $30,000, that means a down payment of $6,000.
The more you understand how your down payment impacts the actual cost of your loan, the more willing you're likely to become to scrape together as much of a down payment as you can put your hands on. Yes, it's that impactful! Here's what you need to know about down payments and their effect on the total cost of your home, car, or other large purchases.
What is a Down Payment?
The down payment is the "skin" you have in the game. Lenders want to see that the item you're buying matters to you enough for you to make a monetary sacrifice to have it. Ultimately, it is the portion you pay for out of your pocket rather than borrowing money to cover the costs.
Most people associate down payments with home loans though most loans require some form of down payment. The larger the value of the item you wish to purchase, the larger the down payment you will need to secure funding.
How Do Down Payments Impact Loan Costs?
You may not realize this, but the amount of down payment you deliver will significantly impact the cost of your loan. The more you pay for a down payment, the less risk lenders take in extending the loan. They often view this as a positive sign and reward you, in turn, with lower interest rates. Over time, these lower interest rates result in enormous savings for borrowers.
Comparison of Down Payment Sizes and Costs
Most people look at the upfront costs of large down payments and despair. However, when you calculate the difference in the total cost of your home, the differences are enormous.
If you buy a $350,000 home and make a 20 percent down payment ($70,000), you only finance $280,000.
| Purchase Price | Down Payment Percentage | Down Payment Total | Amount Borrowed | Interest Rate | Monthly Payments | Total Cost of Purchase |
|---|---|---|---|---|---|---|
| $350,000 | 20% | $70,000 | $280,000 | 6% | $1,678.74 | $674,346.92 |
| $350,000 | 3% | $10,500 | $339,500 | 6% | $2,035.47 | $743,270.65 |
The difference between the two is $68,923.72 over the loan's life, which is a lot of money for the average family. Keep in mind that it is often the case that lenders will also offer a lower interest rate if you're making a larger down payment.
Now let's apply the same analysis to purchasing a $35,000 vehicle on a five-year loan.
| Purchase Price | Down Payment Percentage | Down Payment Total | Amount Borrowed | Interest Rate | Monthly Payments | Total Cost of Purchase |
|---|---|---|---|---|---|---|
| $35,000 | 20% | $7,000 | $28,000 | 6% | $541.31 | $39,479.11 |
| $35,000 | 3% | $1,050 | $33,950 | 6% | $656.34 | $40,430.91 |
Over the 5 year evaluation period of the loan, total payments with the 20% down payment will be $951.80 lower than if you make the 3% down payment. That's not quite the same level of savings you get from our home loan example, but that's due to a mortgage's lengthier loan term.
Pros and Cons of Different Down Payment Sizes
Coming up with a down payment for a loan can be challenging for many people due to various factors, including:
- Insufficient savings. One of the biggest challenges in generating a down payment is having inadequate savings. Many struggle to save enough money to make a substantial down payment, especially if they live paycheck to paycheck.
- High cost of living. The high cost of living can also make it difficult for individuals to save for a down payment. With expenses such as rent, groceries, and transportation, it can be challenging to set aside money for a down payment.
- Debt. Existing debt can also make it challenging to create a down payment. If an individual is already paying off other loans or credit card debt, they may have less money to save for a down payment.
- Low income. Low-income individuals may find saving for a down payment challenging, especially if they struggle to make ends meet.
- High housing prices. In some areas, the high cost of housing can make it challenging to save for a down payment. In these areas, even a modest down payment may be beyond the means of many people.
Overall, coming up with a down payment for a loan can be challenging, but it is a crucial step in securing financing for a significant purchase such as a home or a car. It may require careful planning, budgeting, saving, and seeking assistance from programs that provide down payment assistance.
When evaluating down payment options, it is also essential that you don't totally deplete your savings. You will want to have funds left over for a rainy day. This is huge in case you find out you need a new hot water heater upon moving in or the closing costs were an unpleasant surprise, and it leaves money left over for other priorities and necessities.
If you can put together a meaningful down payment, you can be rewarded with many benefits.
- Lower interest rates. With most lenders, the more significant percentage of the total purchase price you cover as a down payment, the lower your interest rates for the loan will be. It's a reward to you for reducing the lender's risk.
- No need for mortgage insurance. This is only true if you pay 20 percent or more as your down payment, but it is a huge benefit to borrowers who will not need to purchase private mortgage insurance.
- Instant equity in your new home. The more you pay as a down payment, the more equity you have in your home. This helps you secure future loans if the financial need arises.
- Smaller monthly payments. Another considerable benefit of larger down payments is that your monthly payments are less. You will pay less interest on a smaller loan and have less principal to repay, resulting in a lower monthly payment.
Tips for Choosing the Right Down Payment Size
There are many pros and cons to paying more money upfront versus less. The bottom line is that you must do what works for your financial goals and reality. Having all the facts to make that choice will help you make the wiser choice for your needs today and in the future.