Contributing Writer at Tally
April 28, 2021
Making a large purchase, like a car or a home, generally requires financing. When financing something that large, you are bound to run into questions about a down payment. Yes, even when financing an item, you often have to shell out a little cash upfront to make the deal go through.
Going into the process prepared by understanding what a down payment is, how much to expect to pay, how a down payment can help you and your down payment options will ease the process. We'll cover all that and lay out a plan for saving your down payment.
A down payment is an upfront lump sum of cash you pay when financing an asset, including a house, car, boat or any other item.
Your down payment performs several functions. First, it reduces the amount you're financing and lowers your monthly payment. Second, it's a show of faith to the lender that you have the cash to afford this item. Finally, it also gives the lender peace of mind that more of the item's value is covered if you default on the loan, which could force the lender to seize and sell the item.
Keep in mind that some loans have additional costs. For example, homebuyers typically pay closing costs on a mortgage from their down payment savings, reducing their down payment percentage.
For example, if you have $40,000 saved to put down on a $200,000 home, you may think you're putting 20% down. But if the mortgage has $10,000 in closing costs, you're actually only making a $30,000 down payment on the home price. This reduces your down payment percentage to 15%.
Down payments often satisfy lender requirements, but they also offer plenty of benefits to you, the consumer. Here's how a down payment helps you.
No matter how long you finance an item, the more you put as a down payment, the less the monthly payment will be. This makes the item more affordable now and mitigates against it no longer being affordable if your income falls for some reason.
The larger the down payment amount, the less risk the lender is taking by financing the item. Since interest rates are generally set based on the risk the lender takes on, putting more money as a down payment may get you a lower interest rate.
Keep in mind, this isn't a hard-and-fast rule, but it could be a factor.
Home equity — the value of a home minus any mortgages or other loans against it — is a big step in building net wealth. The more money you put down on a home, the lower the loan amount will be. And the lower the loan amount, the more home equity you have.
Private mortgage insurance (PMI) protects a lender from financial loss if a borrower defaults on the loan. Generally, PMI only applies to mortgages with very low down payments, as this is when the lender has the greatest opportunity for financial loss.
Every mortgage lender has different rules regarding their minimum down payments and at what point they require PMI, but most conventional loans will require it when your down payment is less than 20% of the home's purchase price. When doing a refinance, that 20% is based on the home's value.
PMI usually costs 0.5% to 2% of the loan amount, so it can add hundreds of dollars to your monthly mortgage payments and does nothing to help pay down the loan amount. By meeting the lender's down payment requirements, you can save that cash.
The federal government offers several mortgage loan programs for homebuyers with limited down payment funds. Two popular examples are Federal Housing Administration (FHA) loans and United States Department of Agriculture (USDA) loans. FHA loans require only 3.5% down and USDA loans require no down payment.
This minimal upfront cost is enticing, but there is a significant downside to both. Like conventional loans with small down payments, the lender needs insurance should you default on the loan. Instead of charging for PMI, USDA and FHA loans require mortgage insurance premiums (MIP).
Like PMI, MIP can cost you hundreds of dollars per month. However, unlike PMI, MIP has an upfront charge of 1.75% of the home's value and may remain for the life of the mortgage. If you put at least 10% down on your home, MIP remains in place for 11 years. If your down payment is less than 10%, you'll pay MIP until you pay off the home.
MIP costs vary, but generally run 0.45% to 1.05% of the loan amount per year. So if you have a $250,000 FHA mortgage and put the minimum 3.5% down, you could be paying $212.19 per month in MIP. Throughout the 30-year mortgage, this would amount to $76,387.50 in MIP charges.
If you're still building your credit score and want to take out a mortgage or auto loan, you could run into difficulty getting approved. As a high-risk borrower, lenders will want some assurance that you can afford this purchase and upfront payment to reduce the amount you're financing.
A down payment can help with those issues. With a large enough down payment, a lender may look past your credit issues and approve you.
Likely one of the most challenging parts of the home buying process is saving your down payment. This is why there are government-run low-down-payment programs now. However, there's no need to get into these fee-laden loans when you can save a down payment yourself.
Before buying a home, you want to ensure your budget is as clear as it can be, so work on paying off all your high-interest debts. No, we're not talking about that 3%-interest student loan or 5%-interest car loan. We mean that $5,000 credit card with 19.9% interest.
It's these high-interest revolving accounts — debts that have no clear payoff date and can be used multiple times — that can cause issues when budgeting a mortgage payment. Using a structured debt-repayment plan, like the debt avalanche or debt snowball, to pay these off will make it easier to save for a down payment.
You can also use the Tally line of credit1 to expedite your debt repayment process. The Tally line of credit often has a lower interest rate than a credit card, and you can use it multiple times to pay off several cards. Plus, Tally also manages all your credit card payments for you — not just the ones you pay off with the credit line — and offers customizable repayment plans to meet your budget.
Look up average home prices in your area or the area you'd like to live to help gauge the down payment you'll need. Take the average home price and multiply it by 0.20 to get the recommended 20% down payment.
For example, the average home price in the U.S., at the time of this article's posting, is $272,446, so 20% of that would be $54,489.20.
Now, add the typical closing costs in the area on top of that down payment. These vary by area, so contact a realtor to get accurate estimates.
In the U.S., the average closing costs run $5,749, bringing the total you need to save to $60,238.20 to reach a 20% down payment and cover closing costs.
Next, consider your yearly salary and how much you can save. Many experts recommend saving at least 10% of your income toward a down payment.
The mean annual wage in the U.S. is $56,310, according to the Bureau of Labor Statistics, so saving 10% of that would put you at $5,631 per year in savings. Divide the $60,242.20 the average American would need to save to have a 20% down payment and closing costs by $5,631 in savings per year, and you’ll find the average American must save for nearly 11 years to afford a 20% down payment.
If your budget allows it, you can always increase your savings rate and expedite the process. Say you want to purchase that $272,446 home in five years, instead of 11. In this case, you'd need to save $12,048 per year, which is more than $1,000 per month.
If the down payment seems out of reach for you or too far into the future, you can consider other down payment options, including down payment assistance.
There are no federal down payment assistance programs, but some lawmakers are pushing for a $15,000 first-time homebuyer tax credit in the next COVID-19 relief bill. There are, however, numerous state and local down payment assistance programs aimed at spurring growth in certain areas.
Reach out to your local housing office to find out what programs are available and their eligibility requirements. Some of these programs are 0% interest loans, but others may be forgivable grants, which are basically free money.
If you're OK with the amount of time it'll take to save your down payment, you can skip this process. However, for most homebuyers, the reality is you'll likely want to get into your new home more quickly.
This is where you can shop around for mortgages and find out what lenders will accept as a minimum down payment without paying PMI or MIP. Some may go as low as 5%, but you won't know unless you start shopping.
If you find a mortgage lender that's able to approve a 5% down payment without PMI or MIP, your down payment on that $272,446 home falls to $13,622. Add the $5,749 in closing costs and you have $19,371. Divide that by the average yearly savings of $5,631 and you could be ready to buy in just under four years — or even quicker if there are down payment assistance programs in your area.
If none of these options work for you, there are compromises, like the USDA and FHA loans mentioned above. These will include costly MIP, but they also require only 0% and 3.5% down, respectively. And if the equity grows in your home, you can always refinance out of these loans later to eliminate the MIP.
Whether you plan to save for 11 years or jump now by using an FHA or USDA loan, execute your plan and get on your path to homeownership. If you happen into a windfall of cash, like an unexpected bonus, apply this to your savings to speed things up.
Whether you're looking to make a home purchase and need a home loan or are buying a car and need an auto loan, your down payment is instrumental. As a consumer, a down payment can benefit you by:
Lowering your monthly payment.
Lowering your interest rate.
Giving you instant home equity.
Eliminating private mortgage insurance.
Eliminating the need to resort to high-fee government programs.
Improving your approval odds.
The hardest part can be saving that large down payment, as it can sometimes take 5 to 10 years to have enough money to cover the down payment and closing costs. But with careful budgeting, eliminating all your debts, developing a savings plan and taking advantage of down payment assistance, you can expedite the process.
If that's not enough, you can compromise by using one of the government programs that require MIP with a plan to refinance out of that loan as soon as possible.
Whichever plan suits you best, now's the time to get saving for your down payment and working toward homeownership.
1To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) Will be between 7.9% - 25.9% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate.