A down payment is an upfront amount that is given as a portion of the price on a purchase of large ticket items such as houses or cars. These are given in cash or by check when the contract is signed. The balance of the sum due is then given as a loan.
Down payments are principally intended to make sure that the bank or other type of lending institution is capable of recovering the remaining balance that is owed on a loan should the borrower choose to default. In transactions of real estate, the underlying asset becomes collateral that secures the associated loan against potential default.
Should the borrower not repay the loan as agreed, then the bank or institutional lender is allowed to sell this collateral asset and keep enough of the money received to pay off the rest of the loan along with the interest and fees included. In these cases, down payments decrease the exposure risk of the lender to an amount that is smaller than the collateral’s value. This increases the chance of the bank getting the entire principal loaned out back should the borrower default.
The amount of such a down payment therefore impacts the lender’s exposure to the loan and protects against anything that might lessen the collateral’s value. This includes profits that are lost from the point of the final payment to the final collateral sale. The making of this down payment assures a lender that the borrower has capital available for long term investments, further proof that the finances of the borrower are able to afford the item in the first place. Should a borrower not successfully pay down the full loan amount, then he or she will lose the entire down payment.
Down payments on houses bought in the United States typically range anywhere from 3.5% to 20% of the full purchase amount. The Federal Housing Administration helps first time borrowers to pay merely 3.5% as a down payment. In the excesses of the years leading up to the financial collapse of 2007, many banks were making loans with no down payments. On car purchases, these amounts of down payments might be in the range of from 3% to 13%.