Sometimes you don’t have enough money in the bank to buy stuff, so you borrow money to buy the stuff. But if you have some money, it is always better to use it to pay for part of the stuff than to borrow all the money you need to buy the stuff.
In an ideal world, we’d all pay for expensive things like cars and houses and a college education with the money that we already have. But unless you have a Scrooge McDuckian money vault at your disposal, paying cash in full for a car or house or bachelor’s degree feels nigh impossible.
So you take out a loan to pay for the stuff. This loan comes with an interest rate to make it worth the lender’s while. That means that you need to pay back not only the amount of the loan but also an added percentage of extra money. So it’s in your best interest (pun totally intended) to get the smallest loan possible to pay for the stuff.
The less money you’re borrowing, the less interest you’ll pay on top, feel me?
So you use a down payment. You put as much money down as you can afford (more on that in a minute) to make sure you’re borrowing the smallest amount possible. Time to get mathy:
Let’s say you’re buying a $200,000 house, but you don’t have $200,000 in the bank.
I know, I know. But what you do have is a painstakingly saved $40,000, or 20% of the total you need to buy the house. Your interest rate on your loan is 5%. If you don’t use that $40k as a down payment, then over the life of the loan you will pay $186,512 in interest in addition to the $200k you borrowed. That’s almost like your house cost double what you borrowed to pay for it.
But if you use your down payment of $40k, you’ll only be borrowing $160k. And then your interest over the life of the loan will be $149,209. That’s a difference of about $37k saved. And the more money you can afford to use as a down payment, the more you’ll save in interest.
What to do with that saved interest
“But Piggy,” you say, “that saved interest doesn’t seem like much in the grand scheme of things. Why bother saving on interest later when I could spend less money on a down payment right now?”
First off, if $37k doesn’t seem like a lot of money to you then you’re on the wrong blog and you should leave at once to go play golf on your private yacht while your personal friend Beyonce Knowles fixes you a smoothie.
If you recognize the value of $37k later but you’re nervous about spending $40k right now, then make yourself comfortable while I put your totally reasonable fears to rest.
That $37k in interest you’ll save from using a down payment in our example is not just going to sit around and be absorbed into your daily budget. Oh no. You’re going to make that money work for you.
By using a down payment, you’re shrinking your monthly mortgage payments. You’re going to take that difference every month, and you’re going to invest it. And by the power of compound interest (and assuming a modest 7% return over 30 years), you’re going to slowly but surely turn that $37k into $125,438.73.
Or you could pay that money to a giant soulless bank. Your call.
How do you know what you can afford to put down?
Only you can determine how much you can personally afford to put down on a thing. But there are a few things to keep in mind while you’re deciding.
First off, you should never sacrifice your emergency fund for a down payment. So don’t spend all the money you have. The universe has a funny way of knowing when you’re flat broke, and that’s when something will go horribly, expensively wrong. So keep a little money in reserve to show the universe that now is not the opportune time to break your leg/flood your basement/crash your car, etc.
Consider all the potential expenses you have coming up for which you’ll need cash on hand. Do you need to register your car next month? Pay your income taxes? Are you also saving up for grad school or a baby (both totally frightening prospects as far as I’m concerned but they definitely cost money)? Calculate how much you’ll need for these expenses and don’t spend it.
If you’re afraid of getting mathy with it, an online loan calculator is your friend. The loan calculator will let you input as many numbers as you like to figure out your monthly payments and interest over the life of a loan dependent upon different down payments. Experiment with different down payments and schedules to see how low you can get that monthly payment and interest rate without ever having to talk to a lender.
In the end your down payment should be significant enough to lower your total interest paid over the term of the loan while still leaving you with enough cash on hand to pay for upcoming expenses and stave off worst-case scenario emergencies.
There are limits, of course
There are limits to what you should borrow money to buy. You need a place to live, a way to get to work, and the training and education to do said work. Getting a loan and putting money down to buy these things is a means to a necessary end.
You do not need a 52 inch TV on which to watch steroid-enhanced men in spandex bowl each other over in between reminders that we are all slaves to capitalism. You do not need an over-priced handbag with someone else’s name embossed on it to signal to the world that you are A Classy Woman of Means. You do not need sports equipment you could easily rent for the three times a year you actually perform said sport.
I know I’m preaching to the Millennial choir when I remind you that these things are nice to have… if you can afford to pay for them in cash, not just with a small down payment and an 11.9% interest rate credit card. I know that Millennials understand you’d have to be cuckoo for Cocoa Puffs to finance the purchase of luxury items. But I feel obligated to make this reminder because of the overwhelming amount of bad advice out there pressuring young people to use credit and loans irresponsibly.
By all means, save up a down payment for a car to keep your loan amount to a minimum. But owning a PS4 will feel all the sweeter for the knowledge that you worked hard and saved diligently to actually own it in full.
A down payment is a lump of money you use in addition to a loan to pay for a thing. You should use as much money as you can afford for your down payment to avoid paying more money in loan interest over time. And you should only use the down-payment-plus-loan model of finance for large, necessary purchases, not nice-to-have stuff.