Getting a car loan or a mortgage requires you to have good credit. But what if, for some reason, you don’t have a stellar credit score? Does this mean you can’t get a loan? Fortunately, there are things you can do to get around the frustrating effects of bad credit, and one of them is making a large down payment.
A down payment is a money you pay during the early stages of a financial transaction that involves purchasing an expensive item or service using borrowed funds. Down payments are often required when taking out a mortgage, car loan, or another asset.
Can a Large Down Payment Help with Bad Credit?
Yes, it can. Having a bad credit score means it’ll be more difficult to obtain a mortgage, car loan, or any other asset you wish to acquire through a loan. Since lenders pay close attention to your credit report when deciding whether to approve your loan application, you have to offer an alternative so that you’ll have better chances of securing the fund. One way to do that is to offer a large down payment.
The upfront payment serves as an assurance to the lender that you’re committed to paying off the loan. It reduces the lender’s risk and shows that you’re less likely to default.
How Does Down Payment Work?
A down payment, which is sometimes referred to as a deposit, is a percentage of the total amount of the price of the item that you wish to purchase through a loan. It can be as low as 3% or as high as 20% of the total purchase price. The money you use to make the upfront payment may come from different sources, such as a credit card, check, or personal savings.
Down payments aren’t always part of getting a loan. Some lenders offer “zero down” when taking out a house or a car through financing. But making a down payment can be a compensating factor when you have bad credit, especially if you’re offering a large sum of money upfront. Furthermore, it can help reduce the interest rate you need to pay throughout the loan term. It can also cut down your monthly payments.
What are the Advantages of Securing a Loan Through a Large Down Payment?
A large down payment can help you in many ways:
- Lower interest rates – Having bad credit may mean higher interest rates if you get approved for a loan. But by putting more down, you may get the chance to reduce the rates as creditors face less risk.
- Private mortgage insurance – Paying at least 20% of the total price upfront when buying a home may save you from having to cover certain fees, including private mortgage insurance.
- Lower monthly installments – A large down payment may help cut down your monthly installments.
- Qualify for more loans – A large upfront payment will look good on your credit report. It tells creditors that you have the commitment and the funds to pay off your loan, which means you’ll have better chances of securing additional loans in the future.
- Potential equity – There are instances when you use your assets like your home or car as collateral for a loan. By paying a hefty down, you’re starting to build equity, which you can use later when you take out a loan.
What are the Disadvantages of Securing a Loan Through a Large Down Payment?
Just like anything else, paying a large sum upfront also has its disadvantages.
- It can take years to save up to 20% down payment for a home loan.
- In case you manage to save up for a large down payment, you may feel scared to give it up. It may seem like you’re draining your emergency reserves, and you won’t have any cash in case something urgent comes up.
- You may be tempted to use the funds for other purposes like investments or retirement savings.
- It may take a while to realize the advantages of a large down payment.
How to Go About Getting a Large Down Payment?
Owning a car, a home, or other significant assets doesn’t have to be a pipe dream. There are different ways you can raise the down payment you need.
1. Ask from Family or Close Friends
Although asking money from close friends and relatives isn’t an ideal option for many, it’s one method of raising a large down payment that you shouldn’t ignore. Your parents can give you up to $15,000 a year without incurring gift tax.
2. Re-evaluate Your Lifestyle
Another way of saving up cash is to downsize your lifestyle. You should consider moving to a smaller apartment, partying less, or cooking more at home to save on restaurant expenses. If you are a couple who owns two cars, you can sell one of them and use the proceeds to pay upfront for a mortgage.
3. Sell Some of Your Belongings
If you want to buy a house or a car, you should think about selling some of the things that are still useful but you no longer need or use. It could be your CD or book collection, electronics, and even clothes. You can sell them online or through a garage sale.
4. Get a Part-time Job
If you have spare time, why don’t you get a part-time job? It’s a good way of supplementing your income and saving up for a large down payment fast. If you’re good at writing, designing, or bookkeeping, you can work as a freelancer online. You can choose from various side hustles like pet sitting or driving for Uber to help you save for a down payment.
5. 401(k) Loan
You can also take out a personal loan for a down payment on a house. Consider a 401(k) loan if you’re looking for a low cost, simple, and quick way to get the cash you need. It doesn’t require credit checks or lengthy loan applications, and you don’t incur a tax penalty.
How Much is the Ideal Down Payment for a Mortgage?
Putting a 20% down payment gives you higher chances of securing a mortgage loan approval, especially if you have bad credit. But that’s not always the case. A report from the National Association of Realtors revealed that the median down payment for all types of homebuyers in 2019 was at 12%, 16% for repeat homebuyers, and 6% for first-time homebuyers.
Additionally, the minimum down payment for a mortgage depends on the kind of home loan you need. Here’s a calculator you can use.
- The Federal Housing Administration may require as little as 3.5% down payment for FHA loans.
- The US Department of Veterans Affairs doesn’t ask for a down payment when current or veteran members of the military service or their eligible surviving spouses apply for a VA loan.
- The US Department of Agriculture’s Rural Development Program doesn’t require a down payment for its USDA Loans.
- Some home loans from Fannie Mae and Freddie Mac, as well as a few other conventional mortgages, require a minimum of 3% down payment.
Keep in mind that the down payment requirements vary based on your credit history and the lender that you’re doing business with.
How Much is the Ideal Down Payment for a Car Loan?
A 20% down payment for a new car and a 10% down payment for a used one are a good start. But just like with mortgages, the ideal upfront payment will depend on your credit score. Try this calculator to see how much you need for a car loan.
You’ll get higher chances of getting approved for bad credit auto loans if you make a big down payment. Since lenders will face less risk, they will be more eager to take you on as a borrower. You may even get lower interest rates and better car loan terms.
You’ll enjoy several benefits when you pay a larger amount of cash upfront. But make sure that you don’t use up all of your savings. You should always think about how much you can afford without putting yourself or your family at risk of facing undue financial hardship.
Can a Large Down Payment Help You Avoid Negative Equity?
Negative equity happens when your loan is bigger than the value of your property. There are a lot of factors that could lead to negative equity, such as a decrease in prices due to a recession or depression. When you give a large down payment, you can avoid having negative equity.
Other ways to avoid the negative equity trap include increasing the property’s value through renovations or remodeling and reducing the size of your outstanding mortgage by paying extra monthly payments
How Does a Large Down Payment Help You Save on Interest Rates?
The bigger your down payment, the lower your monthly dues will be. That means you’ll also have a smaller interest to pay. Here’s a down payment calculator you can use.
Other ways you can do to save on interest rates are the following:
- Improve your credit score – Having an excellent credit score is one of the best ways to get lower interest rates. Don’t worry if you currently have bad credit—develop good borrowing habits and you’ll be on your way to having a better credit score.
- Debt consolidation – Consider consolidating your debt, if you currently have several existing loans with high-interest rates, into a single personal loan with a lower interest rate.
- Sign up for automatic payment – If you set up an automatic payment, you may be eligible for a lower interest rate. This applies to mortgages, car loans, and other personal loans.
Conclusion
Making a larger down payment can work in your favor, especially if you’re looking for bad credit auto loans or home loans. But be sure to consider the short-term and long-term effects first before you make a decision. Then start saving up once you’ve determined how much you can afford to pay upfront.
What steps have you taken to save up for a down payment? Share your tips in the comments below!
Aidan has been writing about personal finance for over 6 years. Prior to this, he worked as a Corporate Finance Analyst where he specialized in Due Diligence, Company Valuations and more. He is a CFA charterholder.
