The Mortgage Professor: Reader questions about down payments


First of two parts:

Most consumers need to borrow some of the money needed to purchase a home, but lenders will seldom provide it all. Usually they require that borrowers provide some of the money out of their own resources. This is called the “down payment requirement.” The questions about down payments shown below have all been posed to me by prospective house purchasers.

Q: What is the down payment?

A: The down payment is the lower of sale price and appraised value less the loan amount. It is not the same as the borrower’s cash outlay if some of that outlay is used for settlement costs, which is usually the case.

For example, if the sale price is $200,000, the appraised value is $203,000, the loan amount is $175,000 and settlement costs total $5,000, the down payment is $200,000 less $175,000 or $25,000. The borrower’s cash requirement is $25,000 for the down payment plus $5,000 for settlement costs, or $30,000. The higher appraisal value does not enter the calculation.

Q: Why do lenders require a down payment?

A: Reason 1 is that borrowers who have documented their capacity to save the funds needed for the down payment are more likely to have the discipline needed to make the mortgage payments. Down-payment capacity is an indicator of financial discipline. This assumes the down payment was saved, rather than a family gift.

Reason 2 is that in the event that the borrower defaults, the down payment reduces the amount that the lender must raise through the sale of the property. The larger the down payment, the greater the assurance that the sales proceeds will be sufficient to cover the unpaid loan balance.

Q: What is the connection between the down payment and the LTV?

A: LTV (loan-to-value) is the ratio of the mortgage loan amount to the property value, and it is equal to 1 minus the ratio of down payment to property value. For example, if the property value is $100,000 and the down payment $25,000, the down payment ratio is 25 percent and the LTV is 75 percent. While a minimum down payment ratio of 25 percent means the same thing as a maximum LTV of 75 percent, legal and regulatory requirements are usually specified in terms of a maximum LTV because it is less vulnerable to misunderstandings of the types illustrated by the next four questions.

Q: If the appraised value of a home exceeds the sale price, can the difference be applied to the down payment?

A: No, as already indicated, the property value upon which down payment requirements are based is the lower of sale price and appraised value. An appraisal higher than the price is disregarded.

But there is an important exception, called a gift of equity, where the home seller — usually a family member — is willing to sell below market value. In such cases, the lender will use the appraised value, probably based on two appraisals, rather than the lower sale price. Because the difference is a gift, the seller must follow IRS rules to avoid gift taxes, but this is a minor nuisance.

Q: Can a home seller contribute to the buyer’s down payment?

A: No, because of a presumption that such contributions will be associated with a higher sales price. However, subject to limits, home sellers are allowed to pay purchasers’ settlement costs. This reduces the cash drain on purchasers, allowing more of it to be used as down payment.

Q: Can the lender contribute to the buyer’s down payment in exchange for a higher interest rate?

A: No, lenders cannot contribute to the borrower’s down payment. However, cash-short borrowers can select a relatively high-rate loan that carries a rebate or “negative points,” and the rebate can be used to pay settlement costs. This reduces the borrower’s required cash without affecting the down payment.

Q: Can cash gifts be used as a down payment?

A: Only if the gift comes from a relative or live-in partner who can document its source. Gifts from parties to the transaction, such as home sellers or builders, are not acceptable as down payment funds because of the presumption that the gift affects other parts of the transaction, especially the sale price. The lender also must be convinced that the gift is not a disguised loan with a repayment obligation that might reduce the borrower’s ability to repay the mortgage.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at

Last modified: September 9, 2015
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