What are the benefits of larger mortgage down payments?
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UPDATED: Apr 17, 2012
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There are three significant benefits that can be had if homebuyers fork over larger down payments on their mortgage loans. The first of which is reduced monthly payments, the second is the chance to secure lower interest rates, and the third is avoiding private mortgage insurance.
Most lenders advise (if not now require) a 20 percent down payment. However, that percentage can fluctuate depending on borrowers’ financial situations. In most cases, the larger the down payment on a mortgage loan, the better.
Reduce Monthly Mortgage Loan Payments
Larger down payments lead to reduced monthly mortgage bills since down payments reduce the principal on a loan. When the principal is reduced and the term is kept the same, borrowers’ monthly payment will be lower. Additionally, interest that accrues is smaller since the principal is reduced.
For instance, consider a mortgage loan of $200,000 at 5 percent interest over a 30 year term. If a borrower puts 10 percent down, or $20,000, they will see monthly payments of approximately $966. By the end of the 30 year period, our borrower can expect to shell out $167,860 in interest alone.
However, if that same borrower put 20 percent down, or $40,000, their monthly payments would be approximately $859 with interest over 30 years equaling $149,208.
For that extra $20,000 investment, our borrower would save more than $100 a month, and nearly $20,000 in interest.
Larger down payments on mortgage loans almost always equate to long-term savings.
Secure Lower Interest Rates
Interest rates are influenced by two major factors: credit scores and loan-to-value (LTV) ratios. Unfortunately larger down payments won’t directly influence one’s credit score, but they certainly will help reduce LTV ratios.
LTV ratios are determined by dividing the amount remaining on a mortgage loan by the appraised value of the property the loan is securing.
Let’s return to our imaginary borrower from before. He needs a $200,000 loan to secure a property worth $200,000. If he puts 20 percent down, or $40,000, then his mortgage loan will be $160,000. If we divide $160,000 by $200,000, we wind up with an LTV of 80 percent.
A lender is far more likely to award a borrower with an LTV of 80 percent with a better interest rate than a borrower with an LTV of 90 or 95 percent.
Avoid Private Mortgage Insurance
The reason why borrowers are advised to put a full 20 percent down on their home financing is because 20 percent is minimum amount that most lenders require if a borrower wishes to avoid paying for private mortgage insurance (PMI).
PMI is used to protect lenders in the event a borrower defaults on their payments. When a borrower has less than 20 percent vested in their house, the property has little, if any, equity built up. As a result, lenders need the PMI to grant them proper security in the transaction.
PMI is paid on an annual basis, and can be quite expensive, ranging from 0.5 to 1 percent of the entire home’s value.
If our borrower put zero down on his $200,000 home, he can expect to pay anywhere from $1,000 to $2,000 every year on PMI.