How is making a down payment different from getting a smaller loan?

Question

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.

Answer 1

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.

Answer 2

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.

Answer 3

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.

Answer 4

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.

Answer 5

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.

Answer 6

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.

Answer 7

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.