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Does it make sense to put less money down and pay mortgage insurance?

The topic of how much money you should invest when purchasing a home requires comprehensive financial planning, but there are a few simple factors to consider.  Generally speaking, if you put less money down, you can expect to pay more in mortgage closing costs, and possibly pay a higher interest rate.  This will depend upon certain factors such as your credit score, and the type of property you’re purchasing.  So let’s dig into the questions you should ask first before weighing the decision of how much money you should invest.

The interest rate you’ll be charged on a mortgage is driven by a few key factors, the amount of money you put down, the type of property you are purchasing (single family, multi-family, or condominium), your intent of use (primary residence, vacation home, or investment property), the term of your mortgage (10, 15, 20, or 30 years), and your credit score.  It’s important to ask your mortgage lender how these factors affect the interest rate.  For example, if you have a credit score over 740, and purchasing a single family primary residence, the interest rate charged for say 5% vs. 20% down payment is negligible, on the other hand, if your credit score is 640, the impact could be substantial.

The other factor to consider is mortgage insurance, which is typically required if your down payment is less than 20% of the purchase price.  This insures the mortgage lender for a portion of the loan amount in the event of default and the annual premium (paid monthly) can range from .25% up to 1% of the loan amount .  Most home-buyers look to avoid mortgage insurance like the plague, but this could be a mistake when considering your overall financing planning.  In the example above, a buyer with a high credit score purchasing a primary single family home can put 10% down and the mortgage insurance will likely translate into approximately .4% in addition to the interest rate.  That’s to say, if you secure a mortgage at 4% with a 20% down payment, they can receive the same interest rate and pay an additional .4% in mortgage insurance with 10% down.  This may be a better option if you can allocate the money used to invest into home towards other investments such as an indexed mutual fund.  The average long-term rate of return through an indexed fund far exceeds the cost of the mortgage in this example.  With this being the case, it may be wise for the homeowner to put less money down and keep their money invested.

A little known secret is the profit margin for your mortgage lender might be larger if your are putting 10 or 15% down as opposed to 20% down.  That’s because the primary backers of the mortgage business, Fannie Mae and Freddie Mac considers a mortgage backed with mortgage insurance as less risky.  The difference in profit margin is small, but it does give your mortgage lender some room for a small credit off your mortgage closing costs.

Another advantage is mortgage insurance doesn’t have to be for life.  Unless you’re applying for an FHA, VA, or USDA mortgage, the mortgage insurance for a conventional mortgage must be discontinued when you reach a certain level of equity in your home.  There are a few government mandated criteria where the lender must cancel your mortgage insurance.  One criteria is when you pay the mortgage down to less than 80% of the original purchase price, or 75% based upon the current value of the home.  If you can put less money down and have the ability to make extra payments towards the principal balance, you might only pay mortgage insurance for a year, or two.