How Do Down Payments Work?

How Do Down Payments Work? article image.

A down payment is money you contribute upfront on a purchase you are otherwise financing with borrowed funds. Lenders often require substantial down payments on mortgages, auto loans and other financed goods and services (appliances, home repairs, etc.).

A large down payment demonstrates to lenders that you're disciplined enough to save up a lot of cash and gives the assurance that you, the borrower, are invested in the purchase. If you have "skin in the game," the logic goes, you'll be less likely to walk away from the loan without repaying.

Lenders (especially auto financiers) occasionally advertise loans that require zero down payment, but those are typically reserved for borrowers with excellent credit histories, preferably including a long track record of successful loan repayments.

If you are a borrower with less-than-stellar credit, think about offering a down payment larger than would be required on a "conventional" loan available to borrowers with good credit. Doing so could encourage a wary lender to work with you.

How Do Down Payments Work?

Down payment requirements vary from lender to lender and from loan type to loan type. They are usually expressed as percentages of the purchase price—15%, 20% or 25% for example—and must be paid at the time of purchase.

For example, the mortgage on a $200,000 house with a 20% down payment of $40,000 would result in financing of 80% of the purchase price—$160,000.

Because lenders consider down payments marks of borrowers' good faith and hedges against non-payment risk, down payment requirements may vary according to loan applicants' credit profiles. Lenders may require higher down payments from borrowers with lower credit scores, which can indicate short credit histories, past instances of late or missed payments, or even more severe negative credit events such as loan defaults, foreclosures or bankruptcies.

When you apply for a loan that requires a down payment, the amount of the required down payment will be stated, along with the interest rate and any applicable fees, in the loan offer. Like other loan terms, the down payment amount is negotiable; you may get the lender to agree to a lower down payment in exchange for a higher interest rate. (This boosts your overall borrowing costs two ways—by increasing the amount you're borrowing, and the interest you're paying on the borrowed sum.) Conversely, you can often negotiate lower interest rates or fees in exchange for making a larger down payment—a practice also called "buying down the points."

Mortgage lenders typically require down payments to be made in the form of a certified check. Auto financiers may require certified checks as well, but some accept electronic transfers, debit card payments or personal checks. Retailers of appliances, furniture and other large goods may accept down payments by any of these methods or in the form of credit card payments.

What Is a Typical Down Payment on a House?

Within regulated limits, mortgage lenders exercise wide leeway in setting down payment requirements for users with different credit qualifications, just as they do with interest rates and fees. But federal housing programs and industry guidelines make several general practices nearly universal among U.S. home lenders:

  • While they regularly accept down payments of less than 20%, mortgage lenders nearly all require borrowers to buy private mortgage insurance (PMI) on such loans. Lenders require PMI because they consider it risky to provide a loan for more than 80% of a home's market value. If PMI premiums are required on your mortgage, they'll increase your monthly mortgage payments, but you can have them lifted once you've paid off 20% of the principal on your mortgage loan. For this reason, it's a good idea to try to make your mortgage down payment as close to 20% as you can manage.
  • First-time homebuyers with FICO® Scores of 580 or higher can make down payments as low as 3.5% on a mortgage backed by the Federal Housing Administration—an FHA loan. Borrowers with credit scores as low as 500 can qualify for FHA loans with a 10% down payment.
  • Qualifying veterans, service members and surviving spouses can buy homes with no down payment at all through a VA loan backed by the U.S. Department of Veterans Affairs.

What Is a Good Down Payment on a Car?

Auto lenders typically require lower down payments than mortgage lenders do, with car loan down payments of 10% being fairly common. While lower down payments may be possible, there are good reasons to make a down payment that covers more than 10% of a car's value, not least of which is that a larger down payment generally means lower monthly payments on your loan:

  • Beware of loan offers, particularly on new cars, that trade off a lower down payment for a longer repayment period. Stretching a loan out from a standard four-year or even a five-year repayment period to six years offers lower monthly payments but also adds significantly to the overall cost of the car.
  • On most new vehicles, which quickly lose resale value in their first year or two on the road, a down payment of less than 10% and an extended loan term can increase the likelihood you'll end up "underwater" on your loan—that is, owing more than the car is worth.

Does a Large Down Payment Offset Bad Credit?

If you have poor credit, it may be possible to persuade a lender to issue you a loan they otherwise wouldn't if you offer a larger down payment than is typically required. Offering to put 25% down on a car, for instance, might sway the finance officer at a car dealership to consider lending you the remaining 75% of the purchase price.

There are no guarantees such an approach will work, but it's worth a try if you can afford the down payment and are otherwise disqualified for the loan.

If you find your credit is an obstacle to getting credit (or to getting credit at favorable interest rates) another approach to consider is taking steps to improve your credit scores and standing. There are no instant fixes for subpar credit, but taking action today can bring significant improvements in credit scores within a span of six to 12 months.

If you're looking for an opportunity to increase FICO® Scores based on your Experian credit data, consider sharing your cellphone and utility payment information via the Experian Boost®ø program, so that activity can be reflected in your credit score.