By Jack Guttentag
The Mortgage Professor.
I recently set out to write about a new program of down payment insurance but quickly realized that such an article should be prefaced by another one that clarified what the down payment is and what it is not. Look for the piece on down payment insurance next week.
DEFINITION OF DOWN PAYMENT
To a homebuyer, the down payment is the sale price less the mortgage loan amount. It is not the same as the buyer’s cash outlay, although the two are often confused. They differ by the amount of settlement costs charged to the buyer. For example, if the price is $100,000, settlement costs $5,000 and the buyer has cash of $20,000, the amount available for down payment is only $15,000. That is why many homebuyers pay a higher interest rate in exchange for a lender rebate that will cover some or all of the settlement costs.
The down payment is also not the same as the owner’s equity, except on the day of the purchase. Owner equity is what the owner could net from selling the property. Where the down payment is a one-time measure as of the purchase date, owner equity changes month by month. It will rise above the down payment as the mortgage loan balance is paid down, and as the market value of the house rises, due either to property improvements or to market changes. Of course, owner equity can also decline if house prices fall, as many owners discovered during 2007-2009.
APPRAISED VALUE VERSUS SALE PRICE
One of the questions I get with some frequency is whether, in the case where the appraised value is higher than the sale price, the difference can be counted as part of the down payment. The answer is no. From the lender’s perspective, the property value used in determining the down payment is the sale price or appraised value, whichever is lower. The only exception to this is when the seller provides a gift of equity to the buyer, who is almost always a family member. In this case, the lender recognizes that the house is being priced below market and will accept the appraisal as the value. Most lenders in such cases will require two appraisals, and they will take the lower of the two.