If your journey as a home buyer is just beginning, you probably have a lot of questions, many of them about finances. While you’re busy finding the perfect home and deciding what color you’ll paint the walls once you get the keys, we’re here to help answer your questions about the less fun stuff — like the ins and outs of down payments.
Since down payments are, in many ways, one of the final hurdles between you and owning that dream home, they’re an important step in the buyer journey. Here’s everything you need to know!
A down payment is a percentage of a home’s total purchase price. This payment is made by the buyer upfront when finalizing a real estate transaction. If you’ve ever bought a car, you’re likely familiar with the concept — but the bigger the purchase, the bigger the down payment.
Of course, down payments aren’t the only financial considerations you’ll have as a home buyer. Here are some related terms to keep in mind:
Although frequently confused, down payments and earnest money are two separate concepts.
Earnest money is a promise between buyer and seller and often ranges between one and 10% of the purchase price, according to Investopedia. When you provide earnest money, you’re signifying your intent to follow through on a real estate transaction. In return, the seller takes their house off the market.
There are certain situations in which you would get your earnest money back:
- The home doesn’t pass inspection.
- There’s a significant discrepancy between asking price and appraisal price.
- You fail to obtain a mortgage.
- The seller terminates the deal.
If the deal goes through and you officially become a home buyer, your earnest money goes toward the down payment.
Unlike earnest money, a down payment is an agreement between buyer and lender. It represents your agreement to make a regular monthly payment toward a home loan. It’s also calculated as a percentage of the purchase price, but its range is more variable, and there are more benefits associated with a higher down payment (more on that later).
Another related term is closing costs. Closing costs are usually paid only by the buyer and cover things that fall outside a home’s purchase price, including:
- Loan origination fees.
- Title insurance.
- Credit report charges.
- Real estate agent fees.
Because closing costs serve a variety of home purchase purposes, they’re separate from your down payment. That means you’ll need to consider closing costs as an additional fee, while the down payment goes toward the total purchase price.
It’s also important to note the difference between a monthly payment and a down payment. Most significantly, a down payment is one lump sum paid upfront, while a monthly payment is how you’ll regularly chip away at your mortgage — usually for 30 years. However, since a down payment reduces the total purchase price, paying more upfront means each monthly payment will be more manageable.
Since a down payment is a promise from buyer to lender, the amount matters. The “quality” of that promise — that is to say, the amount paid — is one factor a lender uses to determine your interest rate and, therefore, your monthly payment.
Although you may expect the average down payment on a home to sit consistently at 20%, the National Association of Realtors (NAR) found that number to be closer to 12% in 2019. For first-time home buyers, the number was even lower at 6%.
Keep in mind that the average down payment is influenced by many factors, including:
- Total home price.
- Real estate market trends.
- Buyer finances.
- Interest rates.
- Availability of payment assistance.
- Mortgage insurance requirements.
- Calculated mortgage payment.
- Total amount in closing costs.
Therefore, while the average down payment may be 12%, that doesn’t mean you have to follow the crowd. Many people pay more than 12%, while others pay less. That’s why it’s important to know the “down payment rules,” which we’re about to explore.
The minimum down payment for a house acts as a solid benchmark. It can be used to make financial calculations and help you understand the total purchase price, acting as a stand-in until you decide exactly how much you want to pay.
However, that minimum number changes depending on what type of mortgage loan you’re pursuing. Each type has a different lender involved, which means there may be more or less flexibility. Here are a few minimum down payment options, according to U.S. Bank and The Mortgage Reports:
- 0% down payment: A USDA loan and a VA loan each require no down payment.
- 3 – 5% down payment: The 97% loan has a minimum down payment of 3%, while the FHA loan requires 3.5% and conventional fixed-rate loans require 5%. Availability of these loans depends on total mortgage amount and buyer credit score.
- 10% down payment: Adjustable-rate mortgages (ARM) and any jumbo loan will both have minimum down payments of 10%.
While the minimum down payment may look promising as a way to help you afford closing costs or put your savings toward the regular monthly payment, this may not be the best choice depending on your financial situation.
There are plenty of reasons to make a larger down payment, if possible. Here are just a few examples:
If a buyer decides on a down payment less than 20% of the purchase price, lenders may get nervous about the buyer’s ability to make their monthly mortgage payment. That’s why these smaller down payments are “triggers” for mortgage insurance. This adds to the overall price, as the insurance premium is included in your monthly mortgage payment.
The total cost of mortgage insurance depends on multiple factors, including:
- Credit score.
- Down payment amount.
- Type of mortgage.
- Type of loan program.
- Type and frequency of negative credit events.
A down payment is a percentage of your dream home’s purchase price. As such, the higher percentage you pay, the less you’ll have to borrow to make up the difference. A smaller loan can mean a lower monthly payment, a shorter loan term and even better overall credit, since 30% of your credit score is determined by how much credit you actually use, according to Business Insider.
In addition to credit score benefits, a smaller loan amount means smaller interest payments. By paying more upfront, you’ll be paying less overall.
According to The Balance, a higher down payment helps lean the debt-to-income ratio in your favor, which is how a mortgage lender compares a borrower’s monthly income to their monthly payment amount across all debts (auto loans, credit cards, etc.). If you apply for new credit cards or loans in the future, this better debt-to-income ratio will be a good sign for your lender and may lead to better results.
From this perspective, a higher down payment might take a chunk out of your savings right now, but it will help support large purchases in the future.
Although the interest rate on a mortgage is determined by many elements, a larger down payment can do a world of good. According to The Balance, a larger down payment is a more solid, reliable promise, showing the lender you’re financially comfortable enough to pay off a long-term mortgage. Meanwhile, a smaller down payment may signal that you’re more of a risk.
According to the NAR, 58% of buyers source down payments from their personal savings, while 38% use money from selling a previous home. 11% said saving for a down payment was difficult, often because of these factors:
- Student loan payments.
- High rent.
- High mortgage rate.
- Credit card debt.
Luckily, home loans aren’t your only chance for payment assistance. In fact, there are certain loan options focused on helping you make your down payment. While many have requirements like a certain credit score, real estate buyer education programs and income caps, these requirements vary, which means you’re likely to find something that works for you. Most or all down payment assistance programs also require you to work with an approved lender and utilize a specific loan type, including a conventional loan, FHA loan or VA loan.
Keep in mind that down payment assistance is often targeted at first-time home buyers. However, if you haven’t owned a home in three years or more, you’re considered a first-timer — so be sure to take this into consideration when reading the fine-print.
Grants are, essentially, a gift. They never have to be repaid — which is good news for your down payment and your dreams of owning real estate. Offerings vary by state and are generally based on total income or debt-to-income ratio.
A down payment loan is a second mortgage. The cost becomes part of your monthly payment and functions in much the same way as any other loan.
Deferred loans may be familiar to any students out there. They’re second mortgages, but the payments are deferred and only need to be paid when you make a change like moving, selling the home or refinancing your mortgage.
Similar to deferred loans, forgivable loans don’t need to be paid monthly. Instead, they come with an “end date,” which means they’re forgiven as long as you don’t move, sell or refinance before that date. The length of a forgivable down payment assistance loan can vary between five and 15 years, depending on the individual buyer.
Down payments are just one part of the home buying process, albeit an important one. They’re not earnest money, closing costs or monthly payments, although they are closely related to all three. They are calculated as a percentage of a home’s purchase price and can vary widely, from 0% on VA or USDA loans to 20% and higher.
While the average down payment sits at 12%, higher payments have larger benefits, like a more manageable monthly payment or a better interest rate. You’ll also be paying less overall, because you won’t be borrowing as much and therefore won’t be paying as much interest.
However, if a high down payment isn’t currently within reach, don’t give up hope. There are plenty of down payment assistance options to help you finance your real estate purchase. As you research your down payment options, don’t forget the ultimate goal: finding a safe, comfortable house free of costly surprises. Remember, a down payment is just one step on the pathway to getting home.
Ready to officially become a home buyer? Search Bungalo® listings to find the property of your dreams, and don’t forget to reach out with questions about down payments, working with real estate agents, understanding a mortgage or home loan and more.