Down Payment

Refers to a small fraction of the payment made to buy a commodity

A Down Payment is a small fraction of the payment made to buy a commodity and finance the rest using a loan or other method. For example, it is an upfront payment to purchase expensive items like a car, house, etc.

Down Payment

A real-life example of an initial deposit can be of buying a car, for instance, of $20,000, where 25% of the amount, which is $5,000, can be the initial deposit made to buy the car while the rest of the amount can be financed using a loan.

Since the customer is buying up an asset by paying up a fraction of the value of the purchase up front, it gives security to the lending institution.

According to the guidelines made by the central bank of India, only 90% of the value of a home can be financed using a loan, while the rest of the amount (10% of the value of a house) has to be paid upfront before getting the possession of the place. 

A 20% down payment can be made for buying a car, while the rest can be financed using a loan. There are instances where a 0% down payment on a vehicle is availed by dealers but affects a loan in the long term.

Keys

Housing Co-operative requires a customer to pay a large initial deposit, which can start anywhere ranging from 25% to 50% on a Co-operative Apartment. Although this may not be a rule followed everywhere.

In America, the average initial deposit paid on loan is 6% of the loan value of the borrower. It can go down to about 3%, depending upon the borrower's credit score.

Large Down Payments

It can decrease the overall interest paid on a loan in the long run. E.g., The interest paid on a loan of $80,000 over ten years will be way more than the interest paid on a loan of $60,000, which has the same interest rate and the tenure of payment. 

House

In the first year, a loan of $80,000 at an interest rate of 10%, the interest that will have to be paid is $8,000, while with the same interest rate and where an initial deposit has been made of $20,000, the interest will be $6,000 (Interest = ($80,000-$20,000) * 10% = $6,000) providing a saving of $2,000.

In the long term, the loan of $80,000 at an interest rate of 10% over a tenure of 10 years will require paying interest of $50,196, while when an initial deposit of $20,000 has been paid upfront, the total loan of $60,000 will then need the payment of $37,647 in total interest over the same mentioned tenure above. 

This is why a higher initial deposit as much as possible must be made on purchasing an asset to avoid paying more and more interest upfront.

The dealer might provide a lower interest rate to the customer if a bigger chunk of a deposit is made on loan, as the customer will become a less risky debt for the dealer.

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Obtaining Funds

Piggy Bank

  Funds can be obtained to source an initial deposit in the following ways-

  1. Join A First Time Home Buyers Program - Programs like these help one to appropriate sums towards a down payment of a house.
  2.  Help Of Family Members - An amount worth the value of a deposit can be borrowed from the family members on which no interest might be required to pay.
  3. Using Savings - People save some amount from their salaries into a savings account to pay for expenses that might be uncalled in the future.
  4. 401(k) Plan - A 401(k) plan is a retirement savings plan which offers tax savings on a paycheck towards the investment fund.
  5. Stocks, Bonds - Investing in stocks and bonds can provide an investor with lucrative returns, which can be used to fund a down payment.
  6. Cash Value Life Insurance - It is a type of permanent life insurance that lasts for the insurer's lifetime, which ultimately can be used to fund the loan or necessities. 
  7. Keogh Plan - A Keogh Plan is a type of retirement plan for the self-employed or small business that can be utilized towards funding necessities at maturity.

Advantages & Disadvantages

Jar

The advantages can be described below:

  1. More Equity In The Asset - An initial deposit of $20,000 on an asset of $100,000 straightaway means equity of 20% in the asset. "Commodities tend to zig when the equity tends to zag"- Jim Rogers.

  2. Avoiding Private Mortgage Insurance - Lending institutes require mortgage insurance on loans with a low deposit of 5%. In addition, the lending institution requires security if the loanee defaults on payment.

  3. Better Budgeting Options - If $20,000 is saved as a deposit for a home loan, where the lender requires one to pay a 10% payment on a home loan, it will mean that a loan of $200,000 will be granted to you ( Loan Amount = 100/ Down Payment Rate * Deposit Saved for a down payment).
    The point here is if a higher deposit of suppose 20% could have been made on the loan amount, lower E.M.I could have been availed considering the tight budget constraints of a salaried person who has to manage other expenses. 

  4. Less Monthly Installments - A higher down payment on the loan means that there has to be less E.M.I to be paid monthly compared to lower payments or the 0% down payment loans.

    Loss

On the other hand, there are several disadvantages which are mentioned as follows:

1. Less Money for Other Expenses - A large deposit on a loan does have its advantages. Still, if a larger amount is spent on an initial deposit, it would become difficult to manage the other living expenses.

2. Exhaustion Of Savings - People gather the amount using their lifelong savings, which get exhausted immediately when they think of using these savings towards an initial deposit and may take a long time to save again.

3. Opportunity Cost - A very large amount may be invested in a property that gradually increases the owner's equity and would help reap the profits. Still, the property prices rise slowly, and the profits that the owner thinks of realizing might take a lot of time. At that time, the owner could have invested that amount somewhere else where the opportunity cost of investing in that asset could have been more.

Down Payment On House

Determining how much deposit you can pay on your dream house may require considering several factors. 

Pen & Paper

A less deposit on a mortgage could mean that you will be required to pay more interest on your loan, while using a very large amount for a down payment could deplete your financial resources in one go. 

So there has to be a healthy balance between the factors mentioned above.

Before availing of a mortgage loan, the loan officer at a bank may require the applicant to fill up several details related to the estimated deposit amount, savings, and salary of the applicant.

A general rule of thumb is that an applicant will be approved for a loan 2 or 2.5 times his savings. 

For example: If your salary is $80,000, there is a possibility that you may get a loan of around $160,000 depending on the agreement between the lender and the applicant and other terms and conditions.

Garden

After pre-approving the loan application, the loan officer at the bank might tell the applicant the maximum amount on a loan that the applicant can get. Still, other factors should be considered before availing of the loan.

Suppose the monthly mortgage and other debt payments exceed 43% of your gross income, then it should be smart to consider availing yourself of a lower amount on loan than the lender might approve the applicant of getting.  

Assessment Of Lending Risk

Your initial loan payment might help determine the loan-to-value ratio, which allows the lending institutions to assess the risk they will be taking on lending up with the loan.

Balloons

The Loan-To-Value Ratio's formula is dividing the loan amount on the home by the fair market value of the house for which the loan is being sought.

A larger deposit will mean a lesser loan-to-value ratio which in turn means you will be at a lesser risk on loan to the lender, which might result in a loan with a low-interest rate.

An example can be taken to explain how lending institutions determine the riskiness of a loan if the loan-to-value ratio is low. 

Suppose you have paid a 50% deposit on a loan which will mean that you have more skin in the game, and that will mean a less risk factor for the lender, and they may grant the loan.

Key Takeaways
  1. It is a small fraction of a payment made on a loan to buy a commodity.
  2. Large Down Payments are beneficial which results in lower interest payments on a loan.
  3. The amount for down payments can be appropriated using savings, investing in stock and bonds, 101(k) plan, etc.
  4. A Loan to Value ratio helps the lender to determine the risk involved in lending the loan.
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Researched and Authored by Arnav Chaudhary | Linkedin

Reviewed & Edited by Ankit SinhaLinkedIn

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