Q: If I'm looking to buy a house with mortgage rates as low as they are these days, wouldn't it make sense to keep the down payment as low as possible? My logic is that a higher loan-to-value ratio would mean taking maximum advantage of low mortgage rates.
A: The important thing to remember is that while current mortgage rates do reduce the interest cost of buying a home, those rates still represent a cost. So, while there is less of a price to be paid for making a low down payment, it is hard to argue that paying interest on a bigger balance actually works in your favor.
Keep in mind the following three things:
- What do you intend to do with the money? Think about what alternatives you have to putting the money into a down payment. Even with mortgage rates around 4 percent, you would be hard-pressed to earn a higher rate in a savings account these days. You could take your chances and put the money into stocks as an alternative to a larger down payment, but this carries the possibility of compounding your costs if your portfolio goes down.
- A lower down payment could mean a more expensive loan. Interest rates and private mortgage insurance (PMI) are often more expensive for higher loan-to-value mortgages. For example, in some FHA mortgages a small down payment can cost you as much as 50 basis points more in annual PMI than you would pay with a large down payment.
- Less equity could limit your refinancing options. As home prices fluctuate, a small down payment could leave you with an underwater mortgage, and constrain you from refinancing.
There can be good reasons for making a smaller down payment, such as getting into the market while rates are still low, or maintaining a cash reserve for emergencies. However, valid though those reasons may be, they don't change the fact that low down payments come at a price.