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Down Payment: What Is It, and How Does It Work?

Laura - August 25, 2020

LAURA GARIEPY / AUGUST 20, 2020

https://www.rockethomes.com/blog/home-buying/down-payment

Now’s the time to familiarize yourself with the home buying process. You’ll need to set a budget, decide what home features are truly important to you, find a real estate agent, tour houses, make an offer, and finally close the deal. But the absolute first thing you need to do: save for a down payment.

A strong down payment can mean a winning offer on a home. You’ll also need that money to finalize your home purchase. 

Read on to learn more about how down payments work and how big yours will need to be.

What Is A Down Payment?

A down payment is a lump sum of money you pay when the sales transaction is officially processed, known as closing. The amount of your down payment is a percentage of your home’s purchase price and reduces the amount that you’ll need to borrow from your mortgage lender.

For example: If you decide to buy a home for $300,000 and put 20% down, your down payment will be $60,000 and you’ll borrow $240,000 from your mortgage lender.

Down payments are usually required (though there are exceptions, such as with VA loans) to show mortgage lenders that you’re serious about becoming a homeowner, and that you’re able to repay the money they’ve loaned you. You’re less likely to stop paying your mortgage if you already have a substantial amount of money invested in your home.

A down payment also means that your lender takes on less risk even if they do have to ultimately foreclose on and sell your home. That’s because your initial investment can help mitigate any losses that they may incur during the sale.

How Do Down Payments Work?

On closing day, you’ll give the seller your down payment. But that’s at the end of your home buying journey. Let’s back up and discuss how a down payment impacts your ability to really shop for a home in earnest.

Down Payments And The Preapproval Process

To show that you’re a serious buyer, you’ll want to get preapproved for a mortgage before making an offer on a house.

As part of the preapproval process, the lender will require you to prove:

-Your identity
-Your income
-Your employment
-Your creditworthiness
-Your assets

The last one is key because your assets are the funds you’ll use to make your down payment and cover other closing costs. So, having that money in the bank is absolutely critical to even qualify for most mortgages.

Some lenders take it a step further and offer a Verified Approval. To receive a Verified Approval, you actually have your credit pulled and assets verified to get a much stronger preapproval to show potential buyers. It’s essentially saying you’re a safer bet.

Where Does Down Payment Money Come From?

Let’s back up even further. You know you need a down payment. But, where does that money come from?

If you’re lucky enough to have generous relatives who give you the money for your down payment, that’s great! (Just be sure to read this guide on how to use gift money properly.)

But, if you’re like most folks, you’ll need to save up for this expense on your own. While it may seem daunting to amass a large sum of money, here are some things you can do to make it easier (or at least expedite the process):

-See where you can find savings in your budget
-Postpone large discretionary purchases and vacations
-Pick up more hours at work, ask for a raise, or start a side hustle
-Sell unneeded items
-Make sure the money you save or earn actually goes toward your down payment fund
-Automate deposits into your down payment fund so you can’t be tempted to spend the money elsewhere

What Is the Average Down Payment Amount?

You may have heard that 20% is the average down payment on a house. But, while that size down payment has its perks, most home buyers aren’t able to swing that much.

In fact, according to a recent study by the National Association of REALTORS®, the average down payment for a first-time home buyer is 6%. Even most repeat home buyers aren’t hitting the 20% down payment – they average 16%.

Determining Your Down Payment Amount

However, when it comes to saving up for your down payment, you shouldn’t necessarily shoot for average. The amount you’ll need is going to depend on multiple factors like:

-Your debt-to-income (DTI) ratio
-Your credit score
-The mortgage loan type you choose
-Your lender’s specific requirements
-What grants and resources you can get (for first-time home buyers)

Your DTI is the amount of your gross income that goes toward paying on any debt you’re holding. If you’re putting a lot of your paycheck toward servicing debt (say more than 36%, including your home loan), lenders may be concerned that you can’t afford to pay your mortgage. Making a higher down payment could help your case because you won’t have to borrow as much money to buy your home, making your monthly payments more manageable.

Your credit score can have a big impact on how much you need to put down. If you have stellar credit, a lender will be more likely to accept a lower down payment because you’ve demonstrated financial responsibility. Conversely, if you have marginal credit, a lender will be more likely to require a higher down payment because they see lending to you as risky.

Beyond your personal financial situation, the type of mortgage loan that you get will impact your required down payment (see the next section for more details). In addition, the specific lender that you work with may have its own rules regarding down payments, so you’ll have to inquire.

Since saving up for a down payment can be a major hindrance to homeownership for many, there are grants available to help cover the expense as well as other closing costs. If you need this type of assistance, please check with the Department of Housing and Urban Development (HUD). Grants are typically based on your location and financial need.

What Are the Minimum Down Payment Requirements?

Minimum down payment requirements vary by mortgage loan type. Here are the current percentages:

-Conventional: 20% to avoid having to pay private mortgage insurance (PMI); some lenders may go lower
-Federal Housing Administration (FHA): 3.5%
-United States Department of Agriculture (USDA): 0%
-United States Department of Veterans Affairs (VA): 0%

While it may be tempting to just make the minimum down payment (you still have to buy new furniture, after all), making a larger down payment could really help you. Here’s how:

-Get a (potentially) lower interest rate – you’re a lower risk to the bank, so they may reward you
-Enjoy lower monthly payments – you’ll owe less money overall, so each installment will be lower
-Avoid paying PMI on your conventional mortgage (with 20% or more down)
-Be more competitive in a seller’s market – you’ll need to borrow less, which increases your chance of mortgage loan   approval, which means a smooth sale for the seller

How Much Should I Put Down On A House?

As you can see, how much you should put down on a house is a complicated question. Here are some of the most important things to consider to help guide your thinking:

-When do you want to buy? You can buy sooner with a smaller down payment.
-How much do you want to borrow? You can take out a smaller mortgage loan with a larger down payment.
-How is your financial standing? Lots of debt and a marginal credit score could mean having to make a larger down   payment.
-What type of mortgage loan do you want? They each have their own down payment requirements.

The Bottom Line

The home buying process has a lot of moving parts, and your down payment is one of the most important components. It impacts your ability to get a mortgage and to be seen as a competitive buyer in hot real estate markets. Saving up for your down payment and shopping for that perfect home can feel intimidating – but it doesn’t have to.