A down payment is a small percentage of the purchase price of an expensive service or product paid for by a buyer upfront. It is paid in the early stages of a purchase, with the balance cleared within a specified timeframe. One of the most notable characteristics of a down payment is that it happens before the finalization of the sale process. Second, the remaining amount is considered a loan, and the seller is the lender. The third trait of a down payment is that it is insurance that the buyer will pay for the service or item in full.
How Does a Down Payment Differ from a Deposit?
A very thin line distinguishes between a down payment and a deposit. The two are interrelated; thus, some people consider them the same thing. However, there is a notable difference, and it would be wise for anyone involved in purchasing expensive items such as a house to understand the difference. Otherwise, one risks the likelihood of misunderstanding the transaction, hence causing disagreements and possible conflicts. Here are the key differences between the two.
- A deposit is paid to secure a claim on your purchasing property. On the other hand, a down payment is a money paid upfront for a property you have purchased.
- A deposit doesn’t have a specific percentage, though its amount depends on the purchase price. On their part, down payments can be as low as 3.5% for Federal Housing Administration (FHA) loans and 3% for conventional loans.
- In most cases, you will not be allowed to move into a home after paying a deposit, as owners would require full payment of the purchase amount. However, with the agreements made in a down payment model, you could move in after paying 50% of the purchase price.
- When you decide to proceed with the purchase, a deposit becomes part of the down payment.
What Are the Requirements for A Down Payment?
An even better question here is how much money for down payment does one need? While the amount of money you pay as a down payment will depend on the purchase price and your agreements with the seller, the required down payment for a home is 3.5% and above for FHA loans and 3% for conventional loans.
FHA loan is a government-insured housing mortgage issued by banks and lenders and sanctioned by a governmental agency. FHA loans are preferred for several reasons, including insurance costs coverage by the federal government. Other benefits are a low percentage down payment requirement, easy credit qualifications, and low-interest rates, among others.
On the other hand, conventional loans are house loans that do not have the backing of government backing. It requires a down payment of about 3% and has higher interest rates.
Now that we understand the meaning of the two kinds of loans let’s look at the requirements for a down payment. Some of the things you will be required to meet to qualify for a down payment include the following;
A down payment of 3% is required if the conventional loan payment scheme is used. However, it will also be necessary to have private mortgage insurance (PMI). Therefore, to avoid the PMI requirement, your down payment should be above 20%. Nevertheless, you can begin by paying minimum money down for a mortgage of 3% and the PMI until your down payment reaches the 20% threshold when you stop paying the insurance.
However, the borrower can request for insurance costs cancellation when the loan-to-value (LTV0 drops to 80%. Nevertheless, if the borrower does not ask for cancellation, it automatically happens if LTV reaches 78% or below. The arrangement is deemed helpful, especially when you have obstacles paying the 20% down payment at the beginning.
If you’re hoping to use a government-backed mortgage plan, your minimum money down for mortgage payment requirement will be 3.5%. Some of the loans under this arrangement include Veterans Affairs (VA), United States Department of Agriculture (USDA) loans, and FHA. With the smaller down payments, USDA and FHA charge mortgage insurance. However, there are no mortgage insurance requirements for VA loans, but one must pay a funding fee.
Pros and Cons of the Different Down Payments
When considering buying a house through a process that involves paying a down payment, it would be advisable first to weigh the pros and cons of getting into such a mortgage payment method. Secondly, you will need to determine whether you want to start with paying a substantial down payment or you’re just okay with paying the minimum required for a start. Here, we are going to consider each of the scenarios. First, let’s begin with the general pros and cons of opting for a down payment when buying a home or a house.
- It has lower monthly payments compared to other house purchase strategies.
- It helps a home buyer avoid expensive private mortgage insurance.
- It provides some equity in the home. If you can pay about 20%, it would mean the banks or other lending institutions own 80% of the house while 20% belongs to you. Hence, there is co-ownership until you complete the entire payment.
- You are allowed to move into the house as you continue paying the balance.
- It helps the buyer develop a money-saving and spending culture, which could continue even after the home purchase.
- Paying a down payment means tightening the belt on other household and personal spending.
- Down payment ties up money in equity, which means you have foregone other investments to invest in real estate.
- In the beginning, when you pay your down payment, it depletes your savings. It could be that you began saving for this purpose, but we all feel we have less financial backing when we have already used part of our savings.
Pros & Cons of Paying the Minimum Required Down Payment
When you choose to pay the least required amount for a down payment, you will enjoy some advantages as well as disadvantages. As such, based on your financial capabilities, it’s better to weigh the pros and cons and determine whether or not it’s worth it.
- It doesn’t overstretch your finances, as the minimum is 3% or 3.5%, depending on your chosen scheme.
- You can still finance other expenses without a struggle.
- It has a lower mortgage rate than a substantial down payment.
- It requires lesser time to save for.
- Paying a down payment of anything below 20%, especially for conventional mortgages, requires one to pay for insurance.
- A minimum down payment means your equity share is less as the lender has a more extensive holding of your house or property.
- If you opt for a small or minimum down payment, you will have to make mortgage repayments for an extended time than it would take if the down payment were higher.
- It will have higher monthly payments that when one pays higher down payments.
Pros & Cons of Paying High Down Payment
As we noted above, there will be some benefits and detriments. We will focus on the pros and cons to give you an idea of what it entails to pay a high down payment when seeking credit to buy a house.
- When you pay a higher down payment, you have a more significant equity share of the house, and the lender has less. That is, your investment is increased.
- There is no requirement for credit insurance if you have paid more than 20% as a down payment.
- The higher your down payment, the less time it will ultimately take you to settle your mortgage.
- It has much lower monthly payments than when you pay a minimum down payment.
- A higher down payment means you will deplete your savings. So, a lower down payment may be advisable if you do not intend to take this risk.
- The mortgage rates for substantial down payments are higher than lower ones. That’s because there is no default insurance requirement, which means the banks or lenders will be required to hold much higher capital to offer a mortgage financing option that requires a high down payment. It’s the way they protect themselves.
- It overstretches your finances, thus making it difficult to make other investments or cover some of your expenses until you can settle your mortgage in its entirety.
- It requires increased time to save.
Where to Get Money for Your Down Payment
Down payment money comes from savings, so the big question is how or where you get enough money to put into your savings scheme. It’s easy since there are several strategies you can apply to achieve your goal of increased savings. Here are some of the best techniques you could use to boost your savings.
- Have a budget that includes your savings target,
- Set savings goals,
- Prioritize the essential expenses,
- Establish ways to cut spending,
- Open a savings account,
- Increase your sources of income, and
- Sell items you no longer need but are in good condition. Use the money to boost your savings.
Besides savings, there are other ways you can raise money to finance your down payment, including;
- Mortgage or loans,
- Gifts from family and friends,
- Windfalls like inheritance or lottery,
- Sale of an asset such as stocks and government bonds, and
- Non-profit governmental programs intended to support down payment programs. They could include the state or federal governments and their agencies.