Down Payment: What is it & why is it important?
We recently interviewed Katie Epstein, Assistant Regional Manager for Horizon's Chambersburg and York offices. One of the largest hurdles of purchasing a farm or rural property is the down payment requirement that many lenders have, including Horizon.
In simple terms, what is a down payment and what are the typical requirements from a lender?
A down payment is the amount of cash that a buyer puts towards a transaction. I don’t want to confuse it with the deposit that is often a component when you enter into a sales agreement. The deposit is a nominal amount usually $500 to a few thousand dollars due when a sales agreement is signed and will go towards the larger down payment needed for the purchase.
As an example, most lenders including Horizon Farm Credit require a 20 to 30 percent down payment to purchase a farm. With current land prices in our area, that can be a significant amount, so knowing the down payment requirement of a lender is important to help you plan for future purchases that may be many years down the road.
I will note that Horizon has the flexibility to allow the down payment either in the form of a cash down payment, first lien equity in another property or a combination of both.
Now let’s talk about the importance of down payments. Why do lenders want to see a significant down payment and why can down payments also be beneficial to the borrower?
The purpose of a down payment is multifold to a lender.
First, a cash down payment or equity in another property shows your commitment to the purchase having your own money invested, which brings confidence to the lender and even seller to complete the sale.
The ability to gather the down payment also indicates strong financial management skills, a source of income that will likely support repayment of the loan, and low outstanding debt obligations competing for repayment – all of which are appealing to a lender.
Lenders often refer to loan to value requirements, meaning the amount of a loan they are willing to lend based on the value of the collateral. So the inverse of a 20% down payment is an 80% loan to value. I often find if someone is able to meet the loan to value requirements, they are typically more likely to meet the repayment ratios as well.
All of these things are a strong testament to the management ability of a borrower, which is one of the areas the lender will be assessing in making a loan decision.
A sufficient down payment and lower loan to value is also beneficial to you as a borrower because usually it means more options and better terms from the lender. Not only does the required down payment provide access to the remaining funds needed for the purchase in the form of a loan yet also allows a lower loan amount which in turn saves on interest costs over the life of the loan and makes for a lower payment. Mathematically this equates to higher equity which could free up capital to be used for improvements and/or put you in a position to grow the business more quickly.
It also gives you as the borrower and owner some ability to withstand adversity that might pop up in the future. Specifically, that you are more likely in a position to refinance to lower payments, go interest only for a period of time if cash flow is tight due to a crop failure, or some other reason, or sooner able to take out additional loans to make necessary improvements to the property.
A down payment requirement can be a barrier to entry, especially for young or beginning borrowers. How can farmers overcome this hurdle?
That’s right. It can be hard for those who haven’t had time to accumulate savings or build equity in a property. However, it distinguishes the dedicated individuals who are willing to plan and sacrifice to get in position. It might mean putting off a farm purchase until you build adequate savings or considering alternative approaches.
Horizon partners with various other programs including the Farm Service Agency and state economic development loan programs to alleviate some of this barrier. I will note that one common characteristic for all programs is that cash flow needs to be strong.
The Jumpstart Grant program which Horizon is currently offering will give 10 $10,000 grants to startup farmers, and one of the qualifying ways to use the funds would be as a down payment on a farm property.
As we wrap up, is there anything else you’d like to share with our listeners about down payments?
I would encourage our listeners to see the value in a down payment and embrace the discipline it takes to save for a farm purchase. This level of dedication will serve you well in owning a farm and will often be the difference between dreaming of owning a farm and actually owning one.