How does my down payment affect the mortgage rate I receive? Can I secure a lower rate by putting more money down on a home purchase?
These are common questions among home buyers, and with good reason. A person could save tens of thousands of dollars over the life of the loan by securing even a slightly lower mortgage rate.
And a bigger down payment could help you accomplish this long-term goal.
This guide explains the relationship between down payments, perceived risk, and interest rates. Home buyers need to understand this connection, because it affects the monthly payments as well as the total amount of interest paid over time.
Yes, Down Payments Can Affect Mortgage Rates
You’ve probably seen or read news stories in the past about mortgage rates rising or falling. These reports often mention the current average rate for a 30-year fixed mortgage, the most popular type of home loan in America.
But here’s something you might not know. Not everyone qualifies for the “average rate” on a mortgage loan. Some borrowers end up paying more interest, while others might pay less.
Why the difference?
Because banks and lenders set mortgage rates based on a wide range of factors, including the borrower’s credit score, the loan amount, and the size of the down payment.
Generally speaking, putting more money down on a home purchase could help you qualify for a lower interest rate. A smaller down payment, on the other hand, might result in a higher rate.
A similar relationship exists with credit scores. Borrowers with higher credit scores tend to qualify for the best mortgage rates available. While those with lower scores typically pay more in interest — and sometimes have trouble just qualifying for a loan.
The reason for this has to do with something known as “risk-based pricing.”
Understanding Risk-Based Pricing
Want to secure a lower mortgage rate? Start by reducing your risk factors.
When you apply for a home loan, the lender will review all aspects of your financial situation. They’ll check your credit score, your income and employment situation, and your total assets and debts.
They’ll also consider the size of your down payment and the type of loan you’re using.
They do this to measure the level of risk associated with each borrower and each loan, as part of a risk-based pricing model.
Definition: Risk-based pricing is a common practice in the mortgage industry where lenders determine the interest rate and terms of a mortgage loan based on the borrower’s perceived risk profile.
Here are some of the risk-related factors that mortgage lenders consider:
- Credit score: This can influence the interest rate more than any other factor. A higher credit score indicates a better credit history and a lower risk of default, leading to lower interest rates.
- Loan-to-value (LTV) ratio: A higher LTV ratio (resulting from a smaller down payment) indicates a higher risk for the lender. A borrower with a lower LTV, on the other hand, reduces risk and will often receive more favorable pricing.
- Debt-to-income (DTI) ratio: A higher DTI ratio suggests the borrower may have difficulty managing debt payments. This results in a higher perceived risk and potentially higher rates as well.
- Employment history: A stable employment history with consistent income is seen as less risky, while frequent gaps in employment could have the opposite effect.
- Type of loan: Government-backed loans like FHA and VA are generally less risky for mortgage lenders because they are insured or guaranteed by the federal government.
Bottom line: The higher the perceived risk, the higher the interest rate the borrower will likely pay. This is because lenders view higher-risk borrowers as more likely to default on their loan, and the higher interest rate helps offset that risk.
Private Mortgage Insurance (PMI) Considerations
To recap: A smaller down payment on a house could result in a higher mortgage rate for the borrower. And on the flip side, putting more money down could help you secure a lower rate.
But there’s another important factor to consider, and that’s mortgage insurance.
The size of your down payment can also determine whether or not you will have to pay private mortgage insurance on the loan. When a conventional loan (that’s not backed by the government) accounts for more than 80% of the home’s value, PMI is usually required.
Definition: Private mortgage insurance (PMI) is a type of insurance that’s often required when a home buyer makes a down payment of less than 20%, resulting in an LTV ratio higher than 80%.
PMI protects the lender rather than the borrower. If the borrower defaults on the loan (i.e., fails to repay it), the PMI policy compensates the lender for financial losses.
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. In addition to helping the borrower secure a lower mortgage rate, a larger down payment can take PMI out of the picture.
FHA loans also require mortgage insurance, but the rules are different. All borrowers who use an FHA-insured home loan to purchase or refinance a home have to pay mortgage insurance. But the amount can vary based on the loan amount and the LTV.
Conclusion and Key Takeaways
This can be a confusing subject for first-time home buyers. So let’s wrap up with a summary. Here are the most important points to take away from this guide.
- A bigger down payment could help you qualify for a lower mortgage rate.
- In contrast, a smaller upfront investment might require you to pay more in interest.
- Lenders use “risk-based pricing” to determine how much interest to charge each borrower.
- Risk-based pricing considers credit scores, LTV ratios, down payments, and income stability.
- A smaller down payment might also require you to pay for private mortgage insurance.
- PMI is typically required for conventional loans when the LTV ratio exceeds 80%.
- FHA loans always require mortgage insurance, regardless of the down payment size.
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 the lender’s risk exposure. So if you can afford to do it, a larger upfront investment could work to your advantage over the long term.
Disclaimer: This article is intended for a general audience and might not apply to all lending scenarios. We encourage home buyers to obtain multiple quotes from lenders and to compare all costs including the interest rate, fees, and mortgage insurance.
Brandon Cornett
Brandon Cornett is a veteran real estate market analyst and reporter. He has been covering the U.S. real estate market for nearly 20 years. More about the author