What do I need to know about a down payment?

When it comes to navigating through life, there are certain financial traditions and transactions that are difficult to avoid – among them paying taxes annually, saving money for retirement, and setting aside money for a down payment, whether it be for a home, car, or any other major purchase.

There inevitably comes a point when we have our sights set on a big-ticket item we’d like to finance with a loan, and closing the deal requires shelling out a substantial amount of hard-earned money up front as a down payment.

It’s a prospect that can be intimidating, unnerving, and altogether off putting. But, as many financial experts point out, understanding the ins and outs of down payments can make a substantial difference in the long-term success of the purchase you’re preparing to make.

What’s a Down Payment and What Types of Purchases Require One?

To be clear, a down payment is cash that’s paid upfront in an expensive purchase. It typically covers a small percentage of the purchase, with the remainder often being financed in some way.

By far the most well-known purpose of such a down payment is the purchase of a home. But that’s hardly the only use for such a sum of money.

“A down payment is money you’re putting toward an item or a service. It could even be money you’re putting toward a layaway purchase in a store,” explains Lori Askins, of New York-based BR Finance Solutions.

The Standard Down Payment

For a home purchase, the down payment is typically 20% of the home’s selling price. That means if the property is listed for $400,000, the standard minimum down payment would be $80,000.

While there are exceptions to that rule, which we’ll get into below, they’re becoming less frequent in the wake of the housing market collapse of 2008, which revealed many risky and unsound mortgages being offered by financial institutions across the country and led to a historic wave of foreclosures. These days, banks and other lenders are more likely to stick to the 20% rule of thumb.

For an auto loan, however, it’s much harder to pinpoint a standard down payment, experts say. Some people strive to put as much money down as possible or even pay in cash. But with so many dealer financing promotions aimed at getting customers behind the wheel of a new car, if there is a standard down payment, it’s rarely in the 20% range.

“I haven’t seen someone put 20% down on a car ever,” says Ronit Rogoszinski, a certified financial planner and founder of the New York-based Women & Wealth Solutions. “The amount I typically see is 10%, because a car is a depreciable asset. It has already lost its value when you drive it off the lot, so it’s a very different mindset in terms of what kind of money you want to put into something that depreciates from day one.” (That said, if you owe more on your car than it’s probably worth, make sure your auto insurance policy covers that gap in the event you total the car. )

More Exceptions to the 20% Rule

When it comes to home purchases, there’s a handful of cases when the buyer is not required to provide a 20% down payment.

For instance, first-time home buyers could be required to provide as little as 3.5% down, thanks to the Federal Housing Administration, a government agency that assists mortgage lenders with making loans to such individuals. By guaranteeing a portion of the loan, the FHA frees banks to lend to people who may have less money on hand for the down payment or who have lower credit scores. Many states and cities offer their own low-down-payment programs for first-time buyers as well.

Yet another exception to the 20% rule is mortgages for active duty and retired members of the military, who have access to zero-down payment VA loans through the Department of Veterans Affairs, says Askins.

There are also instances when a stellar credit history can translate into a smaller down payment being required. “If you have really amazing credit — and when I say amazing, I mean excellent, tier-one credit — then you may be eligible to put less down,” says Askins.

Why Banks Prefer a Larger Down Payment

There’s a reason for the 20% rule of thumb. The way banks see it, they’re still protected if a home’s value drops by up to 20%. What’s more, a buyer who puts down a big chunk of money has more skin in the game, so to speak.

“The down payment encourages home buyers to not walk away from their mortgage, because you don’t want to lose all that money you put down,” says Askins. “For the banks it’s less risky when there’s a larger down payment. They know you’re more likely to follow through if you just invested 20% of a $400,000 mortgage, as opposed to someone who put put zero down.”

What’s more, a bigger down payment gives the buyer more power when it comes to finalizing the the details and terms of a mortgage, says Rogoszinski. You might be able to score a lower interest rate if you offer to put more money down.

“The more you bring to the table, the better you can negotiate other features,” Rogoszinski explains. “Sometimes with big banks it’s black and white, but there might be smaller places where you can negotiate.”

How a Down Payment Affects Your Purchase

In general, when financing a purchase, a bigger down payment also means your monthly payments will be lower, and you’ll ultimately pay much less in interest.

For example, take that $400,000 house. If you’re able to put down $100,000 (25%) instead of $80,000 (20%), your mortgage payment would drop by almost $100 a month, and you’d pay about $35,000 less in interest over the life of the loan, assuming a 30-year fixed-rate mortgage at 4.0%.

And there’s yet another reason why a 20% or greater down payment is your best bet, specifically with regard to home purchases. That reason is something known as private mortgage insurance (PMI). It’s a part of the home purchase many first-time buyers are not fully familiar with.

Home buyers who don’t have a 20% down payment are required by the lender to purchase additional mortgage insurance, which has a significant impact on your monthly out-of-pocket expenses. PMI, which is designed to protect the lender in the event you default on the loan, is just like any other insurance, meaning you must pay a monthly insurance premium. And the payments can add hundreds of dollars to your monthly mortgage bill.

“People, when they come to the table to look at mortgages, are surprised when they get hit with PMI. Unless you have 20%, you need to factor in PMI,” says Rogoszinski.

It’s also important to note, says Rogoszinski, that until you build up 20% equity in your home, you’re not allowed to take advantage of refinancing (which can lower your monthly mortgage payment if interest rates drop.)

But once you’ve achieved this 20% equity benchmark, you can hire an appraiser to have your home assessed and provide the report to your mortgage holder. If the house is in good condition, you may be allowed to eliminate the PMI, saving still more money each month.

Saving Up for a Down Payment

One last parting bit of advice from the experts. Accumulating a 20% down payment for a home purchase, or anything else, can be an uphill battle for many people. But try tackling it little by little, over time, to make it more manageable.

“Put it into a savings account and pretend that account doesn’t exist. Pretend it’s invisible, and over time the money will accumulate,” Askins says.