A down payment is money that you pay upfront to the seller when you’re buying a property. The remainder of the money paid to the seller comes from the lender, who lends you that money in the form of a mortgage. The bigger your down payment, the less money you have to borrow, and the lower your monthly mortgage payment will be. Down payments are generally discussed in terms of percentages, e.g. 5%, 10%, or 20% of the sale price.
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Why Do You Need A Down Payment?
The purpose of the down payment is to give the buyer a stake in the property. If the buyer fails to make the mortgage payments, he forfeits the money he put down, as well as any equity he’s accumulated. Thus, the more money a buyer puts down, the lower the risk for the lender. Therefore, a borrower who puts down 20% does not have to pay for private mortgage insurance (PMI), which protects the lender in the event the borrower defaults. Borrowers who put down less than 20% are almost always required to pay PMI on top of their monthly mortgage payment.
Common sources of down payments include savings, such as from a bank savings account, investments, or retirement accounts; money from selling a house you already own; and gifts, usually from a relative. Lenders generally require that the source of the down payment be documented, to ensure that you truly have the money to put down and are not overreaching to buy the property, which would make you a greater risk of default. If all or some of the down payment is a gift, the person providing the gift must show where the money came from and attest that the money is a gift, not a loan.
Most lenders require at least 3% of the sale price for a down payment, and often have a 5% minimum. (FHA loans require 3.5% down if you have a FICO credit score of 580 or more, and 10% down if your FICO score is less than 580.) A lender’s minimum down payment requirements depend mostly on the buyer’s credit history and credit score, and whether the buyer will live on the property. Lenders believe that borrowers who live on the property they are buying are less likely to default because of their motivation to keep their home.
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A bigger down payment means either a lower monthly payment or more house. Consider these examples, all with the same $20,000 down payment:
- Buyer A buys a house for $100,000 with a 20% down payment of $20,000. Therefore, the mortgage amount is $80,000. At an interest rate of 5%, Buyer A’s monthly mortgage payment is $429.46.
- Buyer B buys a house for $200,000 with a 10% down payment of $20,000. Therefore, the mortgage amount is $180,000. At an interest rate of 5%, Buyer B’s monthly mortgage payment is $966.28. Buyer B must also pay PMI, which generally costs 0.3% to 1.5% of the original loan amount.
- Buyer C buys a house for $400,000 with a 5% down payment of $20,000. Therefore, the mortgage amount is $380,000. At an interest rate of 5%, Buyer C’s monthly mortgage payment is $2,039.92. Like Buyer B, Buyer C must also pay PMI.
As you can see, although it is possible to buy a house without a huge down payment, it literally pays to build up your down payment before you make the purchase.