Why do I need to pay a down payment? Doesn’t the bank have that money they could just lend me? I’m good for it.
Banks aren’t real estate companies. They don’t like owning real estate, and try hard not to start. In order to have some kind of guarantee that borrowers pay them back, banks require some sort of collateral, or something pledged as security for repayment of the loan. If the borrower doesn’t pay back the loan, then the bank can take the collateral. Collateral could really be anything of value, like a necklace, or the title to a vehicle. In real estate, that collateral takes the form of the property.
If the borrower fails to pay back the loan, the bank becomes the owner of the property. But, banks don’t like owning real estate. Banks want another bit of coercion to get the borrower to pay back the loan. That bit is the down payment. The down payment is similar but not the same as the Loan-to-Value ratio.
Reasons Banks Require Down Payments
- Proof the buyer is financially ready. Being able to save up a big chunk of money is a good indicator of financial intelligence and an indicator that the borrower has the wherewithal to pay the bank back.
- Skin in the game. If the bank made a loan with 0% down, it would be much easier for a borrower to simply ‘walk away’ if he decided he couldn’t make the periodic payments on the loan. Having significant money into the property means losing that money upon failing to pay back the loan. That’s much harder to do.
- Avoid a loss. If the bank is in the position to foreclose, or take possession of the property, it now must determine what to do with the property. Banks don’t like to own real estate. They aren’t good landlords (usually). They would rather sell the property quickly at a below-market value then hold on to it and pay insurance and property tax and upkeep. But the bank put up a bunch of money at a retail price to help the borrower purchase the house. That means they will take a loss. That down payment helps to cover the loss the bank incurs.
- Protect the borrower. If the market happens to take a downturn and the buyer has to sell quickly, the loan is less than it would have been with no down payment. This helps the borrower avoid being ‘underwater’ or owing more than the sale price of the house. In that terrible scenario, the borrower needs to move, but can’t sell because he doesn’t have enough money to pay the loan off. He probably is having difficulty making payments, causing the bank to be in a position to foreclose, and take possession of the property.
Ways to Avoid or Minimize the Down Payment
- Rent. This avoids buying anything. But, it doesn’t bring your investing further along.
- Occasionally, banks will offer a loan with a very low or even 0 down payment. These are hard to find, and for the reasons above, are risky for both the bank and the borrower.
- Find a government-guaranteed loan. The most well-known is the FHA (Federal Housing Administration) loan. These loans can have a down payment as low as 3.5%.
- Decrease your down payment and pay PMI (Private Mortgage Insurance). We will talk more about this later. For now, this is a private insurance that pays the bank back if the borrower fails to make the payments. This has a monthly cost that the borrower pays.
- Save up! Wait a year, decrease expenses, save up that down payment.