Conventional wisdom no longer applies on size of down payment

Homebuyers are often advised to have at least a 20 percent down payment or face the likely additional expense of private mortgage insurance.

But this year, at least, that counsel would not have saved them as much money as in the past.

Rules put in place in late 2008 by Fannie Mae and similar rules adopted by Freddie Mac are less favorable to borrowers who put down 20 to 25 percent, considered the industry minimum. (Fannie and Freddie are the government-controlled companies that establish the underwriting standards for most of the nation's loans.)

For most people, it turns out, smaller down payments result in lower interest rates. Whether that benefits borrowers in the long term, though, is open to debate.

Take, for instance, borrowers who want to buy a $400,000 home and have a credit score of 720, which is considered very good.

In late August, such borrowers who had $80,000 saved for a 20 percent down payment would have qualified for a 4.875 percent rate on a 30-year fixed-rate loan, according to Regina Mincey-Garlin, an owner of RCG Mortgage in Montclair, N.J.

But that was also the rate offered to borrowers putting down only 5 percent, and therefore required to have private mortgage insurance.

Oddly, those who put down 25 percent, or $100,000, were saddled with a higher interest rate, 5.375 percent, Mincey-Garlin said.

The underwriting rules from Fannie Mae and Freddie Mac consider borrowers in the 20 to 25 percent down payment category to be the riskiest, in part because they are not required to carry private mortgage insurance. At higher down payments, however, rates begin to fall.

Amy Bonitatibus, a spokeswoman for Fannie Mae, said the policy was not meant to encourage lower down payments, which some have seen as the main culprit in the foreclosure crisis.

"It's just a less risky loan from our point of view," Bonitatibus said, because the lender's exposure to foreclosure losses is largely eliminated by mortgage insurance.

She said the policy did not benefit only Fannie Mae and lenders that sell loans to the company.

Borrowers benefit, too, she said, especially those who would otherwise have had to stretch for a bigger down payment and leave themselves with no financial cushion.

These borrowers can instead save the extra cash they might have put toward a bigger down payment, keeping it for emergencies.

Besides, Bonitatibus noted, as soon as borrowers pay off enough principal to reach a 20 percent equity position in the mortgage, insurance is no longer required.

While borrowers who take out mortgage insurance can indeed enjoy lower interest rates, their monthly payments will be larger than those who made the larger down payments, because the loan itself is bigger.

A borrower who put down 25 percent for a $400,000 home would make a monthly mortgage payment of $1,680, while the borrower who put 15 percent down would pay $1,906 — or $1,799 in principal and interest, plus an additional $107 monthly in mortgage insurance.

The mortgage insurance is tax deductible, so depending on a borrower's financial circumstances, the net mortgage liability would probably be less.

Mincey-Garlin says she still advises borrowers to make a down payment as large as they can, because the increased equity will help them in the long term.

She also suggests borrowers maintain savings equivalent to at least nine months of mortgage payments.

Those who choose to make a lower down payment and expect to terminate their private mortgage insurance after a few years may encounter a harsh surprise, Mincey-Garlin said.

With property values declining, she said, some lenders have balked at releasing borrowers from mortgage insurance.