20

What is the difference between these two things?

  1. $100k loan with $20k down payment to buy a $100k thing
  2. $80k loan with $0 down payment to buy a $100k thing

They seem effectively identical. But in that case, why are down payments even regarded as a thing?

Edit for clarification: In situation #2, you are paying $20k yourself without the involvement of the lender, so you just need an additional $80k to cover the remainder of the $100k. So you are paying $100k in both situations regardless, but in the first, you are making a $20k down payment as part of the loan agreement, and in the second case, you are paying the $20k independent of the loan agreement. In both situations, you have the $20k to spend, but it's just a matter of whether you spend it as the down payment or spend it independently of the loan and just get a lesser loan.

kloddant
  • 521
  • 5
  • 10
  • 36
    One of the answers addresses it, but it's worth correcting up front: If the thing costs $100k, then you either get a $100k loan with no downpayment or an $80k loan with a $20k downpayment. Your scenario #1 ignores the downpayment, and your scenario #2 doesn't explain how you got a $100k thing for only $80k. – chepner Jul 26 '22 at 21:58
  • Weird. I clarified the situation in another comment, but it appears to have gotten deleted somehow. In situation #2, you are paying $20k yourself without the involvement of the lender, so you just need an additional $80k to cover the remainder of the $100k. So you are paying $100k in both situations regardless, but in the first, you are making a $20k down payment as part of the loan agreement, and in the second case, you are paying the $20k independent of the loan agreement. At least, that was how I thought of it prior to reading the accepted answer. – kloddant Jul 27 '22 at 13:09
  • May depend on the country, but in my case right now it is exactly the same from the banks perspective. The only reason they want to know about the down payment is to confirm the legitimity of the purpose of the loan - and that the purpose can be fulfilled after they provide their part of the money. – Tomáš Zato Jul 27 '22 at 13:51
  • What exactly is happening in case 2? Is it that the $100k thing has been purchased for only $80K, or has another $20k come from somewhere other than a loan? – User65535 Jul 27 '22 at 14:46
  • 3
    @kloddant Comments can be deleted at any time for a variety of reasons. You should edit that information directly into the question – MJD Jul 27 '22 at 15:20
  • 6
    The lender doesn't care if you have a "downpayment". The lender cares about the "loan-to-value ratio". Whether you are taking out a loan for 80% of a house because you have cash for the other 20%, or you inherited 20% and are borrowing money to buy out the 80% owned by other heirs, makes no different to the LTV ratio. – Ben Voigt Jul 27 '22 at 19:47
  • Here is possible scenario for buying a 100 K for 80K- the buyer is prepared to accept a non-liquid 20K+ asset as part payment. – user2617804 Jul 28 '22 at 23:19
  • Do you pay the down payment to the bank where you're from? Maybe that's where the confusion is. In that case, it's probably that way just to avoid fraud (the bank needs to know you're not buying an 80k house with their 80k, but actually a 100k house like you're claiming).

    Where I'm from, you don't pay the down payment to the bank. You and the bank both pay your share to a notary who acts as an intermediate with the seller and he promises the bank not to release the bank's loan unless the buyer also paid the money. So the bank knows there's no fraud.

     – FrederikVds Jul 29 '22 at 16:44
  • If the $100,000 item is collateral, the lender will be well familiar with it. So the distinction you are trying to make will not matter to them. One way or the other, they know you will be bringing $20,000 to the table. They don't care how. – Harper - Reinstate Monica Jul 29 '22 at 23:54

7 Answers7

76

They are no different, but the language you are using is different than what is typical.

If you are buying a $100k thing (perhaps a house), and you only take an $80k loan, then you are necessarily using $20k of your own money to buy the house. That is the definition of a down payment: money that you are initially contributing to something that is purchased with a loan.

This would be considered a $100k purchase, an $80k loan, and a $20k down payment. A $100k loan with a $20k down payment would buy a house that costs $120k. An $80k loan with no down payment could only buy an $80k house.

You might think that the bank doesn't care about the actual purchase price: an $80k loan is an $80k loan, whether the house ultimately costs $80k or $200k. However, the house is the collateral that guarantees the loan. Let's say that you stop making payments shortly after you purchase the house. The bank will take the house, sell it, and use the money that they get from the sale to pay off the loan. If the house is only worth $80k at the time of purchase, they might not get enough from the sale to pay off the loan, but if the house is worth $100k+ at the time of purchase, there is a much better chance that the house will be worth more money than is owed at the time you default.

Ben Miller
  • 115,533
  • 30
  • 329
  • 423
  • 3
    You should also mention all the repossession fees and processing costs and auction cut the foreclosure process will burden the owner's equity with. There's the angle of risk assessment too. Owner equity lowers the risk of loss during foreclosure, because the loan balance is the last thing that'll be paid off after the house is sold. Mortgage often requires down payments exactly because of this. – Mindwin Remember Monica Jul 27 '22 at 14:00
  • Can't a down payment also be borrowed money? I though down payment just meant you do a partial payment up front, as a sort of guarantee to the seller, and pay the rest later. – towr Jul 27 '22 at 15:17
  • 10
    @towr Possibly. If you are trying to buy a $100k house, can only get an $80k mortgage, and have no money, you might be able to get another loan to cover the last $20k. From a certain perspective, this might be considered a $20k down payment, but the bank and the seller both have an interest in knowing that you are taking on another debt obligation. – Ben Miller Jul 27 '22 at 15:23
  • If the thing you are buying is a house, is the house always the collateral for itself, or could you use something else as collateral, such as another property or a company or a copyright to some piece of intellectual property that you own? If you are using something else as collateral, then does the lender care about the cost of the house you are buying, or do they only care about the value of what is put up as collateral? – kloddant Jul 27 '22 at 15:49
  • 2
    @kloddant Generally, when you take out a loan to buy a house or a car, the loan is backed by the house or car itself. The bank has a legal lien on the house or car that allows them to take possession of it if you default on the loan. Yes, it is possible to use something else as collateral. For example, if you already own a house that has no lien currently on it, you could take out a mortgage (home loan) on that house, and use the money you get to buy a car or another house. The bank doesn't really care what you do with the money; the value of the house that you already own is what's important. – Ben Miller Jul 27 '22 at 15:56
  • Worth to mention that if your house appraises for less than what you paid, the loan will be reduced to the appraised value and your cash contribution must then increase, so in this sense the loan is "up to a certain value". – crasic Jul 27 '22 at 16:41
  • @crasic wouldn't it be the other way around? if the house goes up in value, then the "amount owed / amount house is worth" ratio goes down (which often means interest rates go down as well, since the loan is less of a risk, ie the equivalent of a higher down payment on a more-expensive house) – Esther Jul 27 '22 at 20:03
  • 1
    @Esther in theory it should go both ways, but what the bank cares about is that the borrower has enough equity to cover forclosure costs even in a down market. If you ask for an $80k loan on a house the seller wants $100k for, you get the 20% down rate if the home appraises for at least $100k. If it only appraises at $90k then as far as the bank's risk management is concerned you only have $10k of equity in a $90k home, and can either put an extra $8k down and get a $72k loan at the 20% down rate, or borrow $80k but at the 11% down rate (probably equal to the 10% down rate). – Dan Is Fiddling By Firelight Jul 27 '22 at 20:27
  • @DanIsFiddlingByFirelight ah, you are speaking of before buying the house, and I am considering what happens if the value increases once you've bought the house for a lower price. For example if you put $10k down on a $100k house (10%) and the house raises in value to $120k a year later, you only owe $90k on a $120k house (equivalent to 25% down) – Esther Jul 27 '22 at 20:28
  • @BenMiller-RememberMonica " you might be able to get another loan to cover the last $20k." --> Hmm. IIRC that is a problem as that $20k should not be secure by the home loan of the bank, else the bank if 2nd in line - and banks rarely like that. If the $20k is not secured, than that is a debt that the bank likely requires prior disclosure before loaning the $80k. Getting a $20k after buying the house might work if you put $20k down, buy house the 80k mortgage and then borrow $20k. To thine own self be true – chux - Reinstate Monica Jul 27 '22 at 21:06
  • @chux-ReinstateMonica - such loans used to be quite common in the UK (back in the 80s/90s); they were marketed as zero-deposit mortgages. The borrower would approach the primary mortgage provider who would agree to lend, say, 80% and then broker the other 20% to another, secondary, lender. The secondary lender would have what was known as a "second charge" on the property (the primary lender having the first charge) and, as their risk was that much higher in a default situation, charge what can only be described as "eye-watering" interest rates. I had one such mortgage once. (cont...) – Spratty Jul 28 '22 at 11:45
  • 1
    (cont...) and I could never recommend it to anyone else. In my case, the secondary loan was backed by a compulsory endowment life insurance policy; the secondary loan and endowment policy together came to nearly as much per month as the primary loan. Still, I was young, foolish, broke (these three things may not be unrelated), in love and desperate to buy a flat and get married - the perfect victim, in fact. – Spratty Jul 28 '22 at 11:47
  • 1
    Pre-2008 financial crisis in the US you could get a 2nd loan for most (all?) of the value of a home above 80% at purchase time and secured as 2nd in line to the primary mortgage. At the time a number of lenders who believed in 'line goes up' economics would do so at a lower premium in interest than the mortgage insurance that's otherwise normally needed if borrowing more than 80% of the value. Post-08 that largely went away as the lenders involved realized how badly they screwed themselves. – Dan Is Fiddling By Firelight Jul 28 '22 at 14:35
23

Because if you make a down payment, you've got skin in the game.

Think about a few scenarios:

  • If you make a down payment and you decide to walk away, you are in trouble with the bank, but you have also lost your own money. That is a big disincentive to abandoning the investment.
  • If you make a down payment, you will also be more inclined to maintain the property than if you don't have a down payment, because if it falls apart you are losing your own money and not just the bank's money.
  • If you make a down payment then you have reason to consider the real-world value of the property, because if you were to resell it you would get the full amount (more if it appreciates like a house usually will, less for a car because it usually drops in value) back, paying off the loan and returning your down payment. If you don't make a down payment then you would be incentivized to over-buy - e.g., get a $100k loan for a property that is really only worth $50k, because you know that if you can't sell it for the full amount it will be the bank's money that is lost and not your own.

In all of these cases, the bank could go after you for the balance of the loan if the loan can't be repaid, but (a) it still has an effect mentally when planning and (b) some people will try to disappear rather than pay a loan back. Down payments are no guarantee, but they help.

Generally speaking, this is reflected in interest rates. The rate for a loan with a 20% down payment will generally be slightly lower than the rate with a 10% down payment, which will generally be slightly lower than the rate with no down payment. Interest rates are a combination of the cost of the money (banks either borrow the money themselves, or they pay interest on deposits that they are loaning out) and risk of default. Higher down payments translate into a lower risk of default.

manassehkatz-Moving 2 Codidact
  • 1,253
  • 4
  • 10
  • Are you assuming that the loan balance is completely gone after foreclosure? Because it might not be the case. In some cases, depending on the contract language, outstanding balances after foreclosure might still be levied (i.e. sent to collections) against the buyer. – Mindwin Remember Monica Jul 27 '22 at 14:03
  • 1
    I am assuming that in many cases (very often with a car loan, less often but at least some of the time with a home loan) that there will be a balance due on the loan after foreclosure, all the more likely if there was no down payment. But I am also assuming that the borrower doesn't care. They skip town, hoping the bank will give up and write it off. Or they declare bankruptcy. But all of that is somewhat less likely with a significant down payment. – manassehkatz-Moving 2 Codidact Jul 27 '22 at 14:07
6

why are down payments even regarded as a thing?

A bank isn't just going to give a normal person an unsecured loan of $80k.They will want the $80k loan to be secured on an asset. The bank cares about the value of said asset compared to the loan amount because it affects the risk to the bank if the borrower defaults.

In many (if not most) cases, the need for the loan to be secured against an asset creates a chicken and egg problem. Without the loan the buyer can't afford to buy the asset, without the asset there is nothing to secure the loan against.

The precise details will vary with jurisdiction and the type of asset, but generally handling the chicken and egg scenario requires the lender to be involved with the purchase process, so they can ensure that the money is used to buy the intended asset, the asset is really worth the price being paid and the lenders interest in said asset is registered. The loaned funds will generally never touch the buyers bank account.

Peter Green
  • 2,945
  • 2
  • 12
  • 14
3

Your examples are misguided. This answer is U.S. specific.

  1. You: Want to buy a house listed for $250,000
  2. Bank: We will loan up to $200,000 for that house; the seller is a loon for listing so high
  3. You: Must come up with $50,000 cash which does not involve getting taking on more debt
  4. Bank: We will give you up to $200,000 to buy that house but require a minimum of 5% ($10,000) down so you'll end up with a 30-year loan of $190,000.
    • If you can come up with at least 20% ($40,000), instead of 5%, then you can avoid paying the monthly PMI on the loan
    • Banks require down payment on mortgages as proof that you are financially responsible. It would be silly to loan someone $200,000 that has just $10 in their bank account; that person is financially irresponsible.
  5. Tax records: House was sold for $250,000 on XYZ date
    • If the assessed value also goes up then so will the taxes
  6. You: Overpaid for a house by $50,000; the bank told you it's only worth $200,000

You can skip steps 2, 3, and 4 if you have an existing $250,000 in your bank account.

MonkeyZeus
  • 8,473
  • 2
  • 23
  • 48
  • 4
    Step 4 is not really clear: the bank says "we will give you $200,000", but they never give $200,000, they give $190,000. So why don't they just say in step 2 "we will loan up to $190,000 for that house"? – user132647 Jul 29 '22 at 08:42
  • 2
    And this answer would be better if it would explain what the down payment is in the end. Is it the $50,000 needed in step 3? Is is the $10,000 needed in step 4? Is it the sum of both, so $60,000? The terminology is unclear to OP, so it would help not to be vague about this. – user132647 Jul 29 '22 at 08:45
  • And step 6 is very strange: why did "you" overpay by $50,000? That does not follow at all from the previous steps... (BTW: +1 for this answer, only adding comments because I see improvements to an already useful answer) – user132647 Jul 29 '22 at 08:46
  • @user132647 I added explanation about the down payment, hopefully this helps you to understand the measures that a bank takes to protect itself. As for the rest of your questions, you want to buy a $250k house but the bank will only give you $200k so you need to make up the difference in cash and qualify for the loan by making a down payment. Yes, in this scenario you would need to bring $60k of your own money. – MonkeyZeus Jul 29 '22 at 12:16
  • Thank, step 6 is clear, my mistake. The downpayment thing is not universal; in my country a bank determines if you are financially responsible by your income. It would be silly to loan someone $200,000 without income, regardless of their bank account. If they have just $10, but earn $100K/Y, they will easily get the mortgage. So aspects about down payments that appear common sense to you might not be so common. – user132647 Jul 29 '22 at 12:44
  • And regarding the last part of your comment: it is obvious that in that scenario you would need to bring $60k of your own money, but that was not my question. The question was if you would describe that as a "down payment of $60k" or not. I gave three interpretations of how much the down payment could be in your example, and still don't understand which interpretation is the correct one. – user132647 Jul 29 '22 at 12:47
  • @user132647 In my country, if you're making $100k/y and cannot come up with $10k for a down payment then that is a big red flag for the bank; it means that you are probably one unexpected expense away from bankruptcy. I stated what the down payment is, it's what the bank asks of you. The $50k difference between the house price and the bank loan is simply money that you'll be giving the seller directly. In the end, the seller receives $50 from you directly and $200k from the bank. – MonkeyZeus Jul 29 '22 at 13:02
  • Maybe 'unexpected expenses' are less common in my country. If somebody at a $100k/y salary needs $10k, and does not have it on their account, it's assumed that they can easily cut back on expenses. Someone without any income can not come up with $10k, no matter how much they cut back. I won't convince you that my country's system is better (and vice versa), but it's good to be aware of different systems. – user132647 Jul 29 '22 at 13:17
  • @user132647 The currency symbol is $ in the question and in my answer. I'm not sure why you thought I knew and answered for your country but I added a disclaimer to the beginning of my answer. – MonkeyZeus Jul 29 '22 at 13:22
  • Sorry? I never said that I thought that you knew and answered for my country... Where did you get that idea? Your answer was fine as it was. – user132647 Jul 29 '22 at 13:27
-1

Another way to think about it:

If you have $20k and take a $80k loan with no down payment, you get to keep your $20k.

If you have $20k and take a $80k loan with a down payment, you have to invest your $20k in the loan collateral.

gerrit
  • 3,213
  • 2
  • 24
  • 44
  • Why is this downvoted? Is something wrong with my answer? In this case, I would appreciate feedback. – gerrit Jul 29 '22 at 07:18
  • Didn't downvote, but this does not really answer the question... The question is "How is making a down payment different from getting a smaller loan?", you talk about the same loan with and without down-payment. – user132647 Jul 29 '22 at 16:18
-1

I’ll address your question first, but I think you are missing a key element in how the loan works (escrow).

A down payment is not part of the loan agreement, it is part of the sales contract.

The lender requires the borrower to INFORM them of such for multiple reasons (fraud, risk assessment, regulatory compliance), but it is not part of the loan, and doesn’t involve the lender. No part of the down payment will be paid by or to the lender (although you could have multiple lenders).

In short, neither of your scenarios actually exist.

You can have

  1. $100k loan with buyer paying $0 to seller + fees to buy a $100k thing
  2. $80k loan with buyer paying $20k to seller + fees to buy a $100k thing

Or even (not so common but has happened)

  1. $103k loan with buyer paying $0 to seller + fees to buy a $100k thing

The main thing to understand is that in the typical situation with a loan, the only money going directly from the buyer to the seller is the due diligence, everything else goes through a third party, the escrow agent.

The down payment (if any) goes to the escrow agent, the amount of the loan, the agents commission (if any) goes to the escrow agent and is then disbursed.

Since everything goes through escrow, a “loan” with a down payment would not make sense. Who would the money go to? Back to the buyer? Just don’t do it. To the lender? Just make the loan less. If it goes to the seller, that’s someone outside of the loan which is between the buyer and seller.

The sales contract will specify who puts in what and what each gets out, and the escrow agent will be responsible for divvying things up.

jmoreno
  • 1,355
  • 8
  • 15
-1

I feel most answers are missing the essential point here. Lemme pull arbitrary numbers out of my sleeve :

  • A: For a 100k loan, you'll end up paying 125 if you count interest, plus 20k down.
  • B: For a 80k loan w/ same interest and schedule, you'll pay 100.

Case A makes the bank 5k more than B, 25k more in case of reposession.
But wait, there's more !

From the other side of the transaction:

  • A: Invest 100, get 125 in repayment or 100+20 in repo value
  • B: Invest 80, get 100 or 80 repo value

Now is where the magic happens :
Because the bank is lending you 100 but getting 20 up front off the risk, they're basically going to loan you only 80.
You're still borrowing 100 though ! In the long term, you'll have paid 125+20 = 145.
This becomes, from the bank's perspective :

  • A: Invest 100 risking 80, get 125
  • B: Invest 80, get 100

Besides, a 100k loan usually involves longer repayment periods and higher collateral, guaranteeing the bank a steadier income stream with better repossession capability.

From a risk-adjusted benefit perspective, it's way more profitable (for the bank) to contract a bigger loan with downpayment.

SwiX
  • 1
  • 2
  • 2
    This contradicts other answers. Are you sure that you still pay interest over the down-payment? – user132647 Jul 29 '22 at 16:20
  • If the bank requires a relative downpayment (say 20% in this example) they'll do so regardless of the amount.
    Same logic still applies be it for a 100k loan with 20k, or a 80k loan with 16k down.
    Additionally, this creates incentive to borrow higher amounts as the downpayment "leverage" (20/(100+20) = 1:6) makes it feel cheaper to borrow more ("You mean to tell me it's only 4k harder to borrow 20k more ?!"). Besides, as @jmoreno mentioned, downpayment isn't part of the loan. It's just the bank making sure you pay a part of the sale on your own cash. Editing answer for clarity.     – SwiX Aug 01 '22 at 07:43
  • "You're still borrowing 100 though!" How is that so? Why would you borrow 100K when you only need 80K because of the 20K downpayment? I'm sorry, but the way you explain it here, it makes no sense. – user132647 Aug 01 '22 at 15:12