When making a larger purchase, you may hear the term down payment.

Many people may not understand what that is, however, and how it may or may not benefit them. 

Below we look at a number of common questions to help explain this important financial term. 

What Is A Down Payment?

A down payment is simply a large sum of cash paid upfront on a larger purchase, where the remaining cost will be financed.

What Can I Use A Down Payment On?

There are two typical purchases where a down payment is usually found: the purchase of a home and the purchase of a car.

A down payment is extremely helpful when purchasing a home and is often a necessity with mortgage lenders.

When buying a car, a down payment is not seen as being as important to purchasing the car as a home.

While many lenders will not consider working with you if you have a zero-down payment for a house, car dealers are much more likely to offer financing options and work with you and your financial situation.

How Much Is A Good Down Payment?

Depending on the item purchased, the buyers’ income level, and the buyers’ credit history, the amount for a down payment can vary greatly.

A down payment on a car purchase can vary greatly. In order to gain your business, car dealers may run promotions such as 0% down. Purchasing a new car typically will come with a required higher down payment such as 20% down.

The lowest most mortgage lenders will allow is a 3% down payment on a home using a conventional loan.

In order to qualify for this loan, however, you will probably need a good credit score over 640.

Also, you may need to prove you can afford, based on your income, the monthly payment of the remaining, financed mortgage.

Often purchasing a new home is coupled with a 20% down payment. The reason for that is not being it is required but rather because it provides a lot of benefits as seen below.

Because of the benefits, 20% down on a car or home purchase is a good standard to aim for.

What Is The Benefit Of Using A Down Payment?

Not all down payments are created equal.

A 3% down payment on a home will not afford you the same benefits as a 20% down payment. Below are 3 benefits of a down payment, with each being more beneficial the higher the down payment.

1. Lower Interest

Interest is affected in two different ways depending on the size of your down payment.

First, the more you put down, the less you need to finance, and a smaller amount will be affected by interest.

If you purchase a $100,000 home with 3% down, you are financing $97,000. In comparison, if you buy the same home with 20% down, you are only financing $80,000.

Assuming you have the same interest rate for 3% down as you do for 20% down, your payment will be less with 20% simply because of the amount being financed.

Here is a quick example.

A 30-year mortgage at 5% interest for $100,000 would cost $93,256 in interest alone. In comparison, $80,000 at the length and interest rate costs $74,605. That is a difference of almost $20,000.

Second, a higher down payment may lower your interest rate. The interest rate on a $100,000 dollar house may be lower if you are able to put 20% down rather than 3%. 

2. Lower Monthly Payments

This second benefit is directly connected to the first in how it saves you money.

Using the illustration above, a $100,000 loan has a monthly payment of $537 where an $80,000 loan comes to $429.

3. Avoiding PMI on a Home Purchase

Eliminating PMI, or Private Mortgage Insurance, is the final benefit.

Generally, to avoid this additional cost lenders will require you to put 20% down. If you cannot afford 20% as a down payment, you can normally ask your lender, once your equity in the home reaches 20%, to drop this cost.

Hopefully, this quick article was helpful in explaining what a down payment is and how it can be beneficial for you. 

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