How Down Payments Affect Rates and Mortgage Loan Insurance When Buying a Home

Buying a home is exciting, but one of the challenges is coming up with that down payment. A down payment on a home can be thousands of dollars, and the amount you come up with can affect your mortgage rate and whether you pay mortgage insurance or not.

The first thing to know about down payments is it is not necessary to put down 20%. That is the standard down payment for a conventional loan. But it is not a requirement. If you had to put down that much to buy, many people would be unable to afford it.

That said, a 20% down payment is what you generally need to pay to avoid paying mortgage insurance. If you put down less, the lender's risk rises, so for them to still give you a loan, they may require you to pay for mortgage insurance each month on top of your loan. So, if you do not pay your loan and default, the lender is still paid back. Mortgage insurance is a cost, but it is one that allows you to buy a home, so for many of us, it is worth paying for.

As you are thinking about how much to put down on a home, let's look at the typical minimum down payments for various popular loan programs:

• FHA: 3.5%. This is a very popular program for people with less ability to put down a lot of money, and the rates are good. Mortgage insurance is required.
• VA loan: Zero down and no mortgage insurance, but you have to be active military or a veteran to qualify.
• HomeReady conventional loan: 3% down payment. Mortgage insurance is required.
• Conventional loan with PMI: 3% down.

While many experts recommend putting down as much as you can, there is a down side to doing so. A bigger down payment actually affects your rate of return in a negative way. If you have a home worth $400,000, it will on average gain 5% of value a year. That's $20,000. If you put down 20%, your ROI is 25%. But if you put down 3%, your ROI is 167%.

However, a benefit of a larger down payment is that you will indeed get a lower interest rate for the most part. Banks and lenders often offer better rates to those with a lower loan to value ratio. An increase in your down payment lowers the ratio and will lower the risk to the lender. A lower rate can lower your interest paid over the life of the mortgage, and this often means thousands of dollars you can spend on other things.

If you put down less than 20%, you can bet you will also be paying for mortgage insurance, which can cost you $100 a month or more. Conventional lenders will always offer you an interest rate of .5% or so lower if you put down 20% or more. And you avoid mortgage insurance.

But not every type of loan out there offers a lower rate with a higher down payment. One of the best options out there for people with a lower down payment is without a doubt the FHA program. FHA interest rates are not based upon your credit score or down payment. They are the same rates for virtually all borrowers. If today's conventional rates are 4.5%, the FHA rate will usually be .25% or more lower. This is possible because the FHA loan is backed by the federal government. And you are also paying for mortgage insurance. If you default, the lender gets paid back.

So overall, you will generally pay a lower interest rate and not pay mortgage insurance if you put down more money – 20% in most cases. But this is not essential for everyone, and not as important for all borrowers as some believe. Putting down less and paying mortgage insurance can make sense for the borrower with less cash on hand. If you only can afford to put down 5% and you are renting, you could end up renting for years longer while trying to come up with 15% more to put down on a home.

Many experts argue that it makes more sense to put less down on the home, pay mortgage insurance, and stop paying rent. Plus, if you go with an FHA loan, you can still get a very competitive interest rate, no matter your down payment or credit score

If you are a higher income borrower and you can afford to put down 20%, by all means, do so. But for people who do not have the same financial resources, it is entirely defensible to put down less and pay mortgage insurance, even if you pay a slightly higher rate with a conventional loan. But with FHA, you still get a low rate. So keep these facts in mind when trying to decide if you want to really put down 20% on your home.

References: https://www.consumerfinance.gov/about-us/blog/7-factors-determine-your-mortgage-interest-rate/