Reader question: “My husband and I are planning to purchase our first house soon. Right now we are weighing the pros and cons of putting more money down versus getting a lower interest rate. I told him that the down payment does not really affect the mortgage rate that’s assigned to the loan. But he swears you can ‘buy down’ the rate by coming into the deal with more cash in hand. Does the size of the down payment have any affect on the rate we get?”
When your husband refers to “buying down” the interest rate, he might be thinking of discount points. This where you pay more money at closing in order to secure a lower rate on the mortgage. With this strategy, you are increasing your upfront costs to potentially pay a lot less over the long term. But that’s another subject entirely, and you can learn about it here.
So let’s move on to the question at hand: How does the down payment affect the interest assigned by the lender?
Does the Size of a Down Payment Affect the Mortgage Rate?
The size of your down payment affects a lot of things when you take out a mortgage loan. For one thing, it could determine whether or not you will have to pay private mortgage insurance or PMI on the loan. Generally speaking, a loan that accounts for more than 80% of the home’s value will require PMI coverage.
The down payment amount can also affect the interest rate that is assigned to your mortgage loan. In some cases, a larger investment from the buyer could result in a lower rate. This in turn could significantly reduce the amount of money paid over the term of the loan. Why is this true? It all has to do with risk — or, in this case, risk-based pricing.
Most mortgage lenders use some form of risk-based pricing when assigning interest rates and charging fees on a home loan. What this means, in a nutshell, is that they will charge more when there is a higher perceived risk. On the other hand, a borrower who represents a lower risk for the lender may be able to obtain a better/lower interest rate.
Your credit score says a lot about you, in terms of risk. It shows how you have borrowed and repaid money in the past. But the down payment also weighs heavily when it comes to mortgage pricing. When you put more money toward the purchase price, you are essentially reducing the size of the lender’s stake or investment in the property. This in turn reduces their long-term risk and exposure, primarily where a potential default is concerned. In exchange for reducing the lender’s risk with a larger down payment, you may be able to get a lower interest rate on your loan.
This is a simplified explanation of what is actually a complex process. But you probably get the idea. And the idea is that a down payment can certainly affect the interest rate on a mortgage loan, particularly when risk-based pricing is in use.
Making a larger investment can also help you avoid the added expense of mortgage insurance, or PMI. This is why many people who can afford to do so will put 20% down on a home purchase. This reduces the size of their monthly payments (and the total amount paid overtime) in two ways — by getting a lower interest rate, and by removing the need for mortgage insurance.
The bottom line: Lenders are usually willing to offer a lower rate for a bigger down payment. It’s basically a reward to you, the borrower, for putting more money into the deal and reducing their exposure at the same time. So if you can afford to do it, making a larger down payment could work to your advantage over the long term. You’ll also come into the home with more equity or ownership, and possibly avoid the extra cost of PMI in the process. So the down payment can affect your interest rate and also the long-term costs associated with the loan. Ask your lender how the size of your investment will affect pricing.