Tutorial on How Large a Down Payment to Make
18 April 2006, November 14, 2008
The down payment is the difference between the loan amount and the lower of sale price or appraised value. See What Is the Down Payment?
Many borrowers have no down payment decision to make because they don’t have the money for one. Their challenge is qualifying for a loan without a down payment, for which purpose excellent credit is critically important. Note: When this paper was revised on November 14, ,2008, zero down payment loans had disappeared except for VA loans. The smallest was 3% on FHAs. See The Down Payment.Reemerges.
Borrowers with enough money to make a down payment larger than the minimum, who are not sure exactly how much to put down, do have a decision to make. It is similar to the decision about whether or not to pay points, in that it is best viewed as an investment decision. You pay money now and receive a return in the future. It is a good decision if the return is high relative to other investment options.
There are important differences, however, between investing in points and investing in a larger down payment. One difference is in the amounts required. If you have surplus cash equal to 1% of the loan, you can earn a return of 20% or more by buying down the rate, provided you hold the mortgage for 5 years or longer. The same amount used to increase the down payment will only yield a return equal to the mortgage rate, or a little higher if you are also paying points, but well below the return on points.
To generate a higher yield from investment in a larger down payment, the investment must flip the loan into a lower mortgage insurance or interest rate category. Mortgage insurance premium categories, expressed in down payments, are generally 3-4.99%, 5-9.99%, 10-14.99%, 15-17.99%, and 18-19.99%. Where lenders pay for the mortgage insurance and price it in the rate, they use the same categories.
For example, if a borrower taking a 6% mortgage at zero points with mortgage insurance considers raising the down payment from 5% to 7%, the loan will remain in the 5-9.99% mortgage insurance premium category. The premium will remain the same, and the return on investment will be limited to the interest saved on the reduction in loan amount, which is 6%.
If the borrower invests an additional 5% instead of 2%, however, the loan shifts into the 10-14.99% mortgage insurance premium category. Since the premium is lower, the return on investment rises to 11.6%. (This and all other returns are calculated over 5 years using calculator 12a Down Payment Calculator: Rate of Return on Larger Down Payment.)
Occasionally, a borrower’s desired down payment results in a loan amount slightly above the conforming loan limit—the maximum size mortgage that can be purchased by Fannie Mae and Freddie Mac ($417,000 in 2008). In such case, an increase in down payment that drops the loan amount below the maximum would also reduce the interest rate.
If the increase in down payment from 5% to 10% in the previous example not only reduced the mortgage insurance premium but also brought the loan amount below the conforming loan limit, the rate would drop from 6% to about 5.625%. In such case, the return on the investment in a larger down payment would rise from 11.6% to 17.9%.
When mortgage insurance is paid by the lender and incorporated in the interest rate, the return on an increment to the down payment that flips the loan into a lower rate category is highest when the initial down payment is low. This is seen most graphically in the sub-prime market where risk-based pricing is pervasive. The following schedule is taken from a price sheet of a sub-prime lender on September 9, 2005, and applies to 30-year FRMs made to borrowers with credit scores above 680.
Note that increasing the down payment from 25% to 30% reduced the interest rate only slightly, and the return on investment was only 7.3%. But an increase from 0% to 5% dropped the rate substantially, with a return on investment of 20.3%. All rates of return are calculated from calculator 12a.
While the sub-prime market and zero-down loans were both gone by 2008, I have retained this table because it captures the core truth about investing in a larger down payment. The return on investment is higher the lower the down payment with which you begin.
In sum, investment in a larger down payment earns a return on investment about equal to the mortgage rate unless it drops the loan amount into a lower mortgage insurance premium or interest rate category, and/or below the conforming loan limit, in which case the return is higher. To get the higher return may require a down payment increase of 5% of property value or more.
Readers looking for more can read How Much Should I Put Down?
The down payment is the difference between the loan amount and the lower of sale price or appraised value. See What Is the Down Payment?
Many borrowers have no down payment decision to make because they don’t have the money for one. Their challenge is qualifying for a loan without a down payment, for which purpose excellent credit is critically important. Note: When this paper was revised on November 14, ,2008, zero down payment loans had disappeared except for VA loans. The smallest was 3% on FHAs. See The Down Payment.Reemerges.
Borrowers with enough money to make a down payment larger than the minimum, who are not sure exactly how much to put down, do have a decision to make. It is similar to the decision about whether or not to pay points, in that it is best viewed as an investment decision. You pay money now and receive a return in the future. It is a good decision if the return is high relative to other investment options.
There are important differences, however, between investing in points and investing in a larger down payment. One difference is in the amounts required. If you have surplus cash equal to 1% of the loan, you can earn a return of 20% or more by buying down the rate, provided you hold the mortgage for 5 years or longer. The same amount used to increase the down payment will only yield a return equal to the mortgage rate, or a little higher if you are also paying points, but well below the return on points.
To generate a higher yield from investment in a larger down payment, the investment must flip the loan into a lower mortgage insurance or interest rate category. Mortgage insurance premium categories, expressed in down payments, are generally 3-4.99%, 5-9.99%, 10-14.99%, 15-17.99%, and 18-19.99%. Where lenders pay for the mortgage insurance and price it in the rate, they use the same categories.
For example, if a borrower taking a 6% mortgage at zero points with mortgage insurance considers raising the down payment from 5% to 7%, the loan will remain in the 5-9.99% mortgage insurance premium category. The premium will remain the same, and the return on investment will be limited to the interest saved on the reduction in loan amount, which is 6%.
If the borrower invests an additional 5% instead of 2%, however, the loan shifts into the 10-14.99% mortgage insurance premium category. Since the premium is lower, the return on investment rises to 11.6%. (This and all other returns are calculated over 5 years using calculator 12a Down Payment Calculator: Rate of Return on Larger Down Payment.)
Occasionally, a borrower’s desired down payment results in a loan amount slightly above the conforming loan limit—the maximum size mortgage that can be purchased by Fannie Mae and Freddie Mac ($417,000 in 2008). In such case, an increase in down payment that drops the loan amount below the maximum would also reduce the interest rate.
If the increase in down payment from 5% to 10% in the previous example not only reduced the mortgage insurance premium but also brought the loan amount below the conforming loan limit, the rate would drop from 6% to about 5.625%. In such case, the return on the investment in a larger down payment would rise from 11.6% to 17.9%.
When mortgage insurance is paid by the lender and incorporated in the interest rate, the return on an increment to the down payment that flips the loan into a lower rate category is highest when the initial down payment is low. This is seen most graphically in the sub-prime market where risk-based pricing is pervasive. The following schedule is taken from a price sheet of a sub-prime lender on September 9, 2005, and applies to 30-year FRMs made to borrowers with credit scores above 680.
Down Payment Increase |
Interest Rate Reduction |
Yield on Down Payment Increase |
25% to 30% |
6.60% to 6.55% |
7.3% |
20% to 25% |
6.80% to 6.60% |
9.8 |
15% to 20% |
7.05% to 6.80% |
11.1 |
10% to 15% |
7.35% to 7.05% |
12.3 |
5% to 10% |
7.90% to 7.35% |
17.4 |
0% to 5% |
8.55% to 7.90% |
20.3 |
Note that increasing the down payment from 25% to 30% reduced the interest rate only slightly, and the return on investment was only 7.3%. But an increase from 0% to 5% dropped the rate substantially, with a return on investment of 20.3%. All rates of return are calculated from calculator 12a.
While the sub-prime market and zero-down loans were both gone by 2008, I have retained this table because it captures the core truth about investing in a larger down payment. The return on investment is higher the lower the down payment with which you begin.
In sum, investment in a larger down payment earns a return on investment about equal to the mortgage rate unless it drops the loan amount into a lower mortgage insurance premium or interest rate category, and/or below the conforming loan limit, in which case the return is higher. To get the higher return may require a down payment increase of 5% of property value or more.
Readers looking for more can read How Much Should I Put Down?