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I recently received a letter from my (US) bank, saying that I was prequalified for a mortgage. There were two options, both 30 year fixed rate, for the same home price total:

  • 5% down, with a 6.093% interest rate, and
  • 20% down, with a 6.344% interest rate.

Why would I be offered a lower rate with a smaller down payment? This seems backwards, since 5% would be higher risk for the bank.

And why would anyone take the 20% down option? Anyone who can afford to pay 20% immediately can also pay 5%, and presumably could also pay ahead of schedule while taking advantage of the lower rate. Are there any good reasons to take the 20% option?

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  • 5
    Do you need an additional insurance (PMI) for the 5% case?
    – Solarflare
    May 31, 2023 at 1:09
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    Was there a points buy-down for the 5% down loan?
    – Stan H
    May 31, 2023 at 1:22
  • 3
    Even with the lower interest rate, borrowing another 15% of the value will drive the monthly payments up
    – littleadv
    May 31, 2023 at 1:23
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    @BetterthanKwora we don't know what offers you got and based on what information, so we can only speculate. Generally, banks want to maximize profits while minimizing risk. Loans with less than 20% down will require PMI, which minimizes the risk to the bank, so they may price it slightly lower to entice you. Still doesn't mean it's a good idea.
    – littleadv
    May 31, 2023 at 4:39
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    An unsolicited letter saying you are pre-qualified or pre-authorized for a loan means virtually nothing, at least in the US. It means they think you are worth marketing to, not that you are guaranteed to be offered the loan at the advertised rate... or at all.
    – keshlam
    Jun 1, 2023 at 23:30

2 Answers 2

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First, as ever, the devil is likely in the details. You will almost invariably need to pay for private mortgage insurance ("PMI") on the 5%-down option, which depending on your credit score could probably be estimated in the 25-75 bps per-year range. You'd also need to pay PMI until you reach 20% equity, and so this fully negates (and then some) the interest rate differential between the two options. Moreover, the 5%-down option would quite likely be backed by FHA or a state-agency equivalent, and FHA typically requires a 1% upfront fee or "Points". A 20%-down conforming mortgage typically does not require that level of Points to be paid, and depending on market conditions, you can actually get Points back (i.e., paid to you) on closing.

Second, unsolicited pre-qualification letters are effectively just marketing and are barely worth the paper they're printed on. Caveat emptor.

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They make more money on a bigger loan with the lower rate, either on the payments or when they resell the loan.

It's like how some car dealerships make most of their profits on the financing.

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