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A down payment is the amount, usually stated as a percentage, of the total cost of a property that you pay in cash as part of a real estate transaction.
The down payment is the difference between the selling price and the amount of money you borrow to buy the property. For example, you might make a 10% down payment of $20,000 to buy a home selling for $200,000 and take a $180,000 mortgage.
With a conventional mortgage, you're usually expected to make a down payment of 10% to 20%. But you may qualify for a mortgage that requires a smaller down payment, perhaps as little as 3%.
The upside of needing to put down less money is that you may be able to buy sooner. But the downside is that your mortgage payments will be larger and you'll pay more interest, increasing the cost of buying.
The balance of the purchase price for property after credits for money contributed by lenders.See equity.
The difference between the value of the property and the loan amount,expressed in dollars,or as a percentage of value.
For example, if the house is valued at $100,000 and the loan is for $80,000, the down payment is $20,000 or 20%.
Down Payment and LTV: In percent, the down payment is one minus the LTV—the ratio of loan to value. In the example, the LTV is 80%, and 1 - LTV is 20%. Lender requirements are always expressed in terms of a maximum LTV rather than a minimum down payment because maximum LTV does not generate questions about what a down payment is.
Suppose the house in the example is purchased for $100,000 and the borrower has $20,000 for the down payment, but not the $3,000 needed for settlement costs. The settlement costs are therefore added to the loan amount, raising it to $83,000. The LTV is now 83% and the borrower will be obliged to pay for mortgage insurance.
The borrower may say, “Hold on, I'm putting down the same $20,000 as before.” However, the mortgage insurance requirement is set as a maximum LTV of 80% rather than a minimum down payment of 20%, so the argument is over before it begins. In reality, the down payment is $17,000 or 17%.
Sale Price Versus Appraised Value: Home purchasers who pay less for a home than its appraised value frequently question whether they can use the difference as their down payment. They cannot. The rule is that the property value used in determining the down payment and the LTV is the sale price or appraised value, whichever is lower. The only exception to this is when the seller provides a gift of equity to the buyer, as discussed below.
Gift of Equity: Gifts of equity arise when a house is sold for less than its market value, almost always to a family member. In this case, the lender recognizes that the house is being priced below market and will accept the appraisal as the value. Most lenders in such cases require two appraisals, and they take the lower of the two.
Gifts of equity should be structured to avoid gift taxes, which must be paid on gifts from a single donor in excess of $11,000 per
recipient per year. The maximum gift equals $11,000 x D x R where D is the number of donors and R the number of recipients. For example, if the donors are a couple gifting a family of four, they can provide a total gift of $88,000 without tax consequences. Donors who want to gift more than the amount calculated from the formula should talk to a tax advisor.
Cash Gifts: Lenders will accept cash gifts for some part of the down payment, usually not for all of it. While the rules vary for different programs, it is common to require that the borrower contribute 3% of the down payment.
Lenders require a donor to sign a gift statement affirming that the funds provided are a gift rather than a loan. The lender wants assurance that the transfer of funds imposes no repayment obligation that could put the mortgage loan at risk. Sometimes, however, borrowers induce friends or family members who do not want to make gifts to lend in the guise of a gift.
For example, a house purchaser needs the equity in his current house to make the down payment on a new one, but must close on the new one before the old one is under contract. Because there is ample equity in the old house, the buyer asks a friend or family member to lend the money needed for the down payment, to be repaid when the old house is sold.
This is a bad idea. Not only is it a fraud against the lender, it also involves risk to the donor. Contingencies that could result in not
being repaid include a sharp drop in the value of the old house before it is sold, or the sudden death of the home purchaser.
The home buyer in this situation should be advised to take out a home equity loan on the old house, which can be repaid when it is sold. A home equity lender has a lien on the house and has diversified its risk over many loans. The lender pretending to be a donor has neither.
Land as Down Payment: Many people acquire land in order to build on it later, and the land serves as part or all of the down payment. If the land has been held for some time, the lender will appraise the completed house with the lot, and the difference between the appraisal and the cost of construction is viewed as the down payment.
For example, if the builder charges $160,000 for the house and the appraisal comes in at $200,000, the land is assumed to be worth $40,000. A loan of $160,000 in this case would have a down payment of 20%, or an LTV of 80%.
If the land was purchased recently, however, the lender will not value it for more than the purchase price. If the price was only $30,000 in the above example, the lender will value it at $30,000, and the down payment will only be 15.8%, or an LTV of 84.2%.
Home Seller Contributions: Home sellers often gift buyers, raising the price by enough to cover the gift. The purpose is to improve the buyer's ability to purchase the house by reducing the required cash. The practice is legitimate, provided it is done openly and conforms to the guidelines of lenders and mortgage insurers. For it to work, the appraiser must say that the house is worth the higher price.
For example, Jones offers his house to Smith for $200,000, which Smith is willing to pay. But under the best financing terms available to Smith, he needs $12,000, which he doesn't have.
So Jones and Smith agree that Jones will raise the price of the house to $206,000 and Jones will gift Smith $6,000. Assuming the appraiser goes along, the amount of cash required of Smith drops from $12,000 to $6,360, making the purchase affordable (see the table). Jones gets his price and Smith gets his house, so everyone is happy—except, perhaps, the lender.
|Down Payment (3%)||$6,000||$6,180|
|Total Cash Required||$12,000||$6,360|
|Down Payment (3%)||$6,000||$6,180|
|Settlement Costs (3%)||$6,000||$6,180|
|Gift from Seller||0||$6,000|
|Buyer's Stated Equity||$6,000||$6,180|
|Buyer's Real Equity||$6-12,000||$180-6,180|
Appraisals often ratify sale prices, whether justified or not. If the house is actually only worth the original offer price of $200,000, the buyer has only $180 of real equity—the difference between the original property value and the higher loan amount—rather than $6,180. Less equity means greater loss for the lender if the loan goes into default.
For this reason, lenders and mortgage insurers limit the size of seller contributions. The smaller the down payment requirement, the more critical the issue becomes. On conventional loans (loans not insured by the federal government), it is common to restrict seller contributions to 3% of sale price with 5% down and to 6% with 10% or more down.
Contributions Under FHA: On FHA loans, individual sellers can contribute up to 6% of the price to the buyer's settlement costs, but nothing to the down payment. However, FHA allows approved nonprofit corporations to offer down payment assistance using funds provided by sellers. These include www.nehemiah.org, www.partnersincharity.org, and www.ameridream.org. The combination of direct seller contributions to settlement costs on FHAs and indirect contributions through down payment assistance programs, can add up to 9-10% of the sale price.
Investing in a Larger Down Payment: A larger down payment is an investment that yields a return that consists in part of the interest rate on the money you aren't borrowing. If you put an additional $10,000 down, for example, you are borrowing $10,000 less and you save the interest that you would have paid on it. But there may be other savings as well that make the return higher than the interest rate on the loan.
First, most borrowers pay points or other loan fees expressed as a percent of the loan amount. If you borrow $10,000 less, you save not only the interest but the upfront fees on the $10,000. Fees of fixed dollar amounts don't affect the return because they aren't reduced when the loan amount is reduced.
A second possibility is that the larger down payment reduces or eliminates mortgage insurance, which must be purchased when the down payment is less than 20% of property value. In such event, the return on the larger down payment includes not only the savings in interest and points but also the mortgage insurance that is eliminated by the larger down payment.
Still a third possibility is that the larger down payment reduces the interest rate by bringing the loan amount below the conforming
loan limit, at this writing $322,700. Because the federal secondary market agencies, Fannie Mae and Freddie Mac, cannot purchase mortgages larger than that amount, the market breaks at that point. Interest rates are about 3/8% lower on loans below the maximum.
All these factors are pulled together in calculator 12a on my Web site, “Rate of Return from Investing in a Larger Down Payment.” The calculator will show you, for example, that increasing the down payment from 5% to 10% on a 30-year fixed-rate loan at 7% and two points will yield 13.1% before taxes over eight years. If the larger down payment dropped the loan below the conforming loan limit, reducing the rate to 6.625%, the return on the amount invested in the down payment would be 19.37%.
No-Down-Payment Loans: The availability of no-down-payment loans (NDPs) is a strength of the U.S. mortgage system and also a weakness. Some families become successful homeowners with the help of NDPs. Others, who shouldn't be homeowners, are enticed to try and fail.
NDPs have high default rates. This has been a finding of every study of mortgage defaults that I have ever seen. One reason is that homeowners who borrow the full value of their property have less to protect should economic adversity strike. If they lose their job, or if property values decline temporarily, they lose less from a default than borrowers with equity.
A second reason is that borrowers unable to accumulate a down payment have not demonstrated budgetary discipline and the ability to plan ahead. People able to save money every month before they buy a home are much more likely to meet their monthly mortgage obligations afterwards.
Why do lenders make NDPs? When property values are rising, as they have most of the time since World War II, the risk of default is reduced. Rising values create equity in houses that were initially mortgaged to the hilt.
In recent years, furthermore, lenders have become more confident in their ability to assess the willingness and capacity of borrowers to repay their mortgages. Using credit scoring and other tools, they judge that it is safe to give less weight to an applicant's ability to accumulate a down payment.
Lenders protect themselves, furthermore, by charging higher rates on NDPs. The rate includes a “risk premium” to cover the losses lenders expect from higher delinquencies and defaults.
Just because a lender is willing to give you a NDP, however, doesn't mean you should take it. The risk premiums protect lenders, not you.
Some people are not cut out to be homeowners. When they default, the costs include not only loss of their house, but also having to find another one with all the disruptions to their lives that that typically involves. Plus their credit rating goes into the tank. If many defaulters live in the same neighborhood, the neighborhood can also tank.
Securities as Down Payment: Some investment banks offer home loan plans where they accept the deposit of securities in place of a down payment. If you purchase a house for $200,000, for example, the bank will lend you the entire $200,000, provided you deposit securities worth $40,000 with them. For the bank, the securities provide essentially the same protection against default as a down payment, while discouraging the customer from shifting the account to another bank.
These plans delay the accumulation of equity in the house indefinitely. The customer begins with no equity, and if the payment only covers the interest for the first 10 years, which is a common feature, the only equity buildup is from appreciation in the value of the property. The theory behind this is that the consumer's overall wealth will grow more rapidly if the maximum amount is invested in securities.
In the example, the consumer is in effect borrowing an additional $40,000 to invest in securities. Whether this turns out to be a good idea or a bad idea depends on the yield earned on the securities relative to the mortgage rate. It doesn't make sense to borrow $40,000 at 7% to invest in government bonds yielding 5.5%. It may make sense for consumers investing in common stock, which might yield 12% or more over a long period.