Definitions

Down payment

Down payment

Down payment (or downpayment) is a term used in the context of the purchase of expensive items such as a car and a house, whereby the payment is the initial upfront portion of the total amount due and it is usually given in cash at the time of finalizing the transaction. A loan is then required to make the full payment.

The main purpose of a down payment is to ensure that the lending institution can recover the balance due on the loan in the event that the borrower defaults. In real estate, the asset is used as collateral in order to secure the loan against default. If the borrower fails to repay the loan, the lender is legally entitled to sell the asset and retain a portion of the proceeds sufficient to cover the original amount of the loan.

By requiring a down payment in advance, the lender greatly increases the chance that any such future sale would be able to cover the full amount of the loan, because such a sale only requires the lender to recover the difference between the original selling price and the amount of the down payment, as opposed to the entirety of the original selling price.

If the borrower is unable to pay off the loan in its entirety, he/she forfeits the down payment amount.

Amounts

In the United States home purchases they typically vary between 5% and 20% of the purchase price. With rising home prices in the years from 2000 to 2007, lenders were willing to accept smaller down payments, (sometimes 3% or even zero by providing a combination of 80% and 20% mortgages), so that more individuals can purchase homes as their primary residences. This trend has been reversed since that time.

For car purchases the down payment could be anywhere between 3% and 13%. Similar for purchases of comparable price.

There is more risk for lenders when individuals purchase a home as an investment property. Therefore the lender may charge a higher interest rate and expect a higher down payment.

References

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