Down payment definition

What is a Down Payment?

A down payment is a cash payment made at the beginning of a purchase transaction. It is usually required by the seller of goods or services that are expensive and/or customized for the needs of the buyer. If the sale falls through, then the seller can keep the deposit and recognize it as revenue. The amount of a down payment usually approximates the material cost of the product being sold, so that the seller will not lose if the sale does not happen.

In the case of a lending arrangement, the down payment reduces the total interest expense for the borrower and provides some security for the lender, since someone who has made a down payment is less likely to default on the associated loan.

Accounting for a Down Payment

The recipient of a down payment (the seller) initially records the received cash as a debit to the cash account and credit to the down payments liability account. The entry is not initially made into a revenue account, since the seller has not yet earned the down payment. Instead, it is a liability of the seller. If the sale falls through, then the seller has earned the sale (assuming that the sale contract does not allow the buyer to retrieve the funds), so the seller can record a debit to the down payments liability account and a credit to the revenue account. Or, if the sale is completed in a normal manner, then the down payment is also reclassified as revenue using the same entry.

Example of a Down Payment

Here are several examples of down payments:

• Home purchase down payment. When buying a house, a buyer usually makes a down payment ranging from 5% to 20% (or more) of the property’s purchase price. For example, on a $300,000 home, a 20% down payment would be $60,000, with the rest financed through a mortgage. Making a larger down payment can lower the monthly mortgage payments and potentially eliminate the need for private mortgage insurance (PMI).

• Car purchase down payment. When purchasing a car, whether new or used, buyers often make a down payment of 10% to 20% of the vehicle’s price. For instance, if a car costs $25,000, a 10% down payment would be $2,500. This payment reduces the amount financed, lowering monthly payments and interest costs over the term of the auto loan.

• Business equipment financing. Companies buying expensive equipment, such as manufacturing machinery or commercial vehicles, might be required to make a down payment of 10% to 30% of the equipment’s cost. For example, for equipment priced at $100,000, a 20% down payment would be $20,000, with the remainder financed through a business loan or lease agreement. This initial payment can help secure better financing terms and lower interest rates.

In each of these examples, the down payment serves to reduce the amount that needs to be financed, lower interest costs, and demonstrate the buyer's commitment to the purchase.