What is Down Payment? Meaning with Example

A down payment is one of the many terms you will encounter when taking out a loan, especially a home or an auto loan. It is a crucial concept that every borrower must understand since it can significantly affect the monthly loan obligations. That said, what do you mean by a down payment? 

That is exactly what we shall look into in this comprehensive guide. In addition to understanding the meaning of a down payment and why financial institutions require you to make one, we will also explore the beneficial effects of making a large payment upfront when applying for a loan. 

What is a Down Payment?

The down payment is a one-time lump sum payment that financial institutions require borrowers to make when applying for a loan. It is usually expressed as a percentage of the total purchase price of the asset. Once the required down payment is made, the remainder of the asset’s purchase price is financed through a loan. 

A down payment is often required when making a large purchase, typically a home or a car. However, depending on the financial institution and its policies borrowers may be asked to pay a lump sum upfront to secure consumer durable loans and business loans as well. 

Read More About What is Instant Loan?

Why is a Down Payment Necessary?  

Financial institutions often stress the need to make a down payment whenever you intend to purchase a large asset on a loan. Now that you are aware of what a down payment means, let us look at some of the reasons why it is necessary. 

• Regulatory requirements

In the case of a home or property loan, the Reserve Bank of India (RBI) has strict regulatory requirements that prevent banks and financial institutions from offering a loan of more than 80% of the total value of the asset. To ensure that they meet this regulatory requirement, borrowers are often mandated to make 20% of the total value of the asset as a down payment.

• Risk mitigation 

The loan-to-value (LTV) ratio is a key metric used to assess the risk associated with a loan. The higher the LTV, the greater the risk. Making a down payment to secure a loan reduces the LTV and consequently the risk for financial institutions if the borrower defaults.  

• Commitment indicator 

The down payment serves as a strong indicator of a buyer’s commitment to the purchase. The higher the down payment, the greater the individual’s commitment towards the purchase is deemed to be. 

Down Payment: An Example 

Let us take up a hypothetical example to fully understand the meaning of a down payment and how it affects loans. 

Assume you wish to purchase a home that costs ₹50 lakh. As per RBI’s regulations, you are required to make a minimum down payment of 20% of the total cost of the asset to secure a home loan. This means you would have to pay ₹10 lakh upfront. The remaining ₹40 lakh will be funded through a home loan from a financial institution.

Imagine that the interest rate on home loans is 10% per annum and that you opt for a 20-year tenure. This means that you would have to pay around ₹38,601 each month over the course of the home loan’s tenure. The interest component of the home loan alone would come up to approximately ₹52,64,208 lakh. 

Alternative Scenario

Now, let us consider another scenario where you make a down payment of 30% of the total home’s value. In this case, your initial outlay would be ₹15 lakh, with the remaining ₹35 lakh being funded through a home loan.

If we keep the interest rate and tenure intact, you would only have to pay around ₹33,776 each month over the course of the loan term. Also, the interest component of the loan would only come up to approximately ₹46,06,182 lakh. 

The two scenarios mentioned above clearly demonstrate how the size of a down payment can significantly impact the overall cost of homeownership.

Advantages of Making a Large Down Payment 

Although making a substantial down payment can be quite challenging for most borrowers, it can be hugely beneficial. Here is a quick overview of the various advantages.

• Lower monthly payments

A larger down payment reduces the loan amount, which leads to a reduction in the monthly payments. As evidenced in the two scenarios mentioned above, by marginally increasing the down payment from 20% to 30%, you could lower your EMIs from ₹38,601 to ₹33,776.   

• Less interest paid over time

Since making a large down payment reduces the loan size, you will end up paying less in interest over the life of the loan. As you have already seen in the example above, you could save around ₹6,58,026 lakh in interest costs by increasing the down payment from 20% to 30%.  

• More negotiating power

You could get more negotiating power by making a down payment higher than the minimum recommended amount. In fact, some lenders may even agree to more favourable interest rates or loan terms if you make larger down payments.  

• Easier qualification 

Making substantial down payments could qualify you for a loan more easily, even if you have a lower-than-ideal credit score.

Conclusion  

A down payment is crucial when applying for a loan to purchase large assets, such as a home or a car. Although saving up the funds required for a loan down payment is a challenge on its own, the beneficial effects of making a substantial payment cannot be ignored. From better loan terms and lower monthly payments to reduced long-term interest costs, a well-planned down payment can set you up for financial success.

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