by Simon Wright

Created on: May 28, 2008

Down payments have perhaps never had as much significance as they do today. As world economies move further towards a period of recession and the credit crunch bites, banks are busy tightening their credit policies and raising mortgage interest rates. In addition, borrowers are continuing to get into financial difficulties, leading in some cases to mortgage holders defaulting on their payments and losing their house.

So how do down payments come into this sorry situation and why are they so important? Well, one of the reasons why the credit crunch has been so severe is that banks got used to the practice of offering 100% mortgages. i.e. if you were buying a house for $300,000, the banks were offering you the ability to get a mortgage for that full $300,000 amount rather than requiring you to make an initial down payment (or deposit) on the mortgage. This was a risky strategy on the behalf of the banks and they have hurriedly withdrawn these offers.

Going forward house buyers are going to need to make an initial down payment and typically the amount required is 10% of the purchase price. So, in that $300,000 example, you would need to stump up $30,000 as your initial down payment.

There is a major advantage to borrowers, too, in maximising the amount of down payment that you make. For every dollar that you borrow, you are going to be paying interest. So, for that $300,000 mortgage, it is not $300,000 that you will pay into the mortgage. Rather it will be $300,000 plus all the interest accrued on the reducing capital amount.

For this reason, it is in your interest to maximise the size of the down payment that you make and thereby minimise the starting mortgage amount. Of course, you don't want to use up all of your accumulated savings. This could leave you vulnerable if an unexpected cost emerged, or unable to exploit an investment opportunity. However, you should study your finances and make a judgement on how much you can afford to include in the downpayment. As a minimum you need to stump up the amount that the bank have stipulated but (if possible) you should look to maximise your down payment rather than minimise it.

So, in summary, down payments are increasingly important in this credit crunch era and you're unlikely to get a bank to agree to giving you a mortgage without one. They are a good thing from the borrowers perspective, in that they will minimise the total amount that you end up paying for your house. They do this by reducing the amount of interest that you would otherwise have to pay on your mortgage. However, in deciding how much you can afford to include in the down payment, you need to be cognizant of the need to hold some money back to protect you against any short-term unexpected costs.

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