Why Do Smaller Down Payments Qualify For Lower Mortgage Rates?

If you plan to buy a home, odds are you’ll need a mortgage to help finance the purchase. If that’s the case, you’ll need to come up with a down payment to get approved. 

But just how much do you need for a down payment? And can you get away with a small upfront amount? 

Considering the cost of homes these days, your down payment will cost you tens or even hundreds of thousands of dollars, depending on the home you buy. But there are minimum amounts accepted that may help make homeownership more attainable. And it’s even possible you may even be able to secure a lower interest rate despite the lower down payment amount.

But why would you be rewarded with a lower rate if you come up with a lower down payment?

Down Payments And Mortgages

A down payment is a percentage of the price of a home that is paid upfront when a deal closes on a real estate purchase. It is required when taking out a mortgage to finance a home purchase and goes toward the purchase price of the property. 

Down payments differ based on several factors, including the type of mortgage being applied for and the borrower’s financial profile and credit score. That said, in Canada, the minimum required is 5% of the purchase price for insured mortgages and 20% for uninsured. 

Mortgage lenders require a down payment because it reduces their overall risk when lending large amounts of money. The bigger the down payment, the less that needs to be borrowed and the lower the risk on the part of the lender if the borrower ever defaults on the mortgage. Buyers who are able to come up with larger down payments are less likely to default on the mortgage because they have more of their own money invested in the property. 

Find out the difference between a home deposit and a down payment.

Why Do Smaller Down Payments Qualify For Lower Mortgage Rates?

While it may come as a surprise to many Canadians, there’s a reason why smaller down payments qualify for lower mortgage rates. That reason is mortgage default insurance. 

What Is Mortgage Default Insurance? 

Mortgage default insurance— commonly referred to as “CMHC mortgage insurance” —  is a premium borrowers pay when their down payment is less than 20%. CMHC insurance can cost between 2.4% to 4% of the mortgage amount, the exact rate depends on the down payment you make. Typically, the lower your down payment the higher your CMHC cost will be. 

CMHC insurance can be paid upfront in one lump sum or you can opt to pay it with your mortgage. This will allow you to pay for the premium in more affordable payments. 

How Does Mortgage Default Insurance Lead To Lower Mortgage Rates? 

Mortgage default insurance is a premium you pay when your down payment is less than 20%. But what does it do? Essentially, mortgage default insurance protects the lender from borrowers who default on their mortgage. 

The risk lenders take when lending money is significantly reduced when borrowers pay the mortgage default insurance premium. It basically covers lenders of any loss they may incur due to borrowers defaulting on their mortgage. For example, let’s say a borrower stops making payments and the lender is forced to seize the property and resell it to recoup the lost funds. If the lender is unable to sell the property for the amount that is still owed on the mortgage, the insurer will reimburse the lender for the loss they incur.  

As such, when a mortgage is insured, lenders are able to provide the mortgage at a lower cost, which is usually shown in the form of a lower mortgage interest rate. That said, while a lower mortgage rate may lead to money saved on interest, it is often offset by the premiums paid on the mortgage default insurance. 

What Is The CMHC Insurance Rate?

When you apply for a mortgage with a high LTV, your lender will inform you of the exact price of the insurance policy, which is calculated as a percentage of the mortgage loan and is based on the down payment amount. The higher the LTV, the higher the insurance premiums will be, as is shown in the following table:

Pros And Cons Of Making A Smaller Down Payment

A smaller down payment might be easier to save for, but there are some downsides to it as well that you should be aware of.

Pros

• Money can be invested elsewhere – If you sink all your money into a down payment, you’ll have little leftover to invest in another investment vehicle. By making a smaller down payment, you can open up your pool of available funds to be invested somewhere else. 
• Lower interest rate – As mentioned, a smaller down payment often means a lower interest rate, as the lender is protected with mortgage default insurance and can pass some of those savings on to you in the form of a lower rate.
• More affordable – Saving tens of thousands of dollars or more for a down payment can take a lot of time and effort. But with a smaller down payment, you may be able to realize your dreams of homeownership sooner rather than later.  
• Won’t drain your savings – Rather than use up every dollar you have saved, you can keep some available for a rainy day with a smaller down payment. 

Cons

• Borrow a larger amount. A smaller down payment means a higher loan amount. That means you’ll owe more, which can take a lot longer to pay off your mortgage. 
• CMHC mortgage insurance fees. If you don’t make at least a 20% down payment, you’ll be slapped with additional fees in the form of mortgage default insurance premiums. This can offset any savings you may have realized with a lower interest rate.
• Higher monthly payment. The smaller the down payment, the higher the loan amount. And in turn, that means higher monthly mortgage payments, especially if you choose a shorter amortization period. 
• Pay more interest. While you may be able to secure a lower interest rate in many cases with a smaller down payment, you’ll end up paying more in interest over the life of the loan simply because of the higher loan amount you’re stuck paying. 

Additional Reading

What Is An Amortization Schedule?

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The Canadian Mortgage Stress Test in 2021

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Pre-Approved vs. Pre-Qualified

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FAQs About Small Down Payments

What’s the minimum you can put down on a mortgage?

The minimum down payment amount needed depends on the price of the home you intend to buy and the type of mortgage you’re applying for. Your financial profile and credit score may also impact the amount that your lender may require.  However, in general, houses valued under $500,000 require at least 5% as a down payment, while houses valued at over a million require at least 20%. 

Can you get a zero down payment mortgage? 

Every mortgage requires a down payment in Canada. But you may still be able to get a zero down payment mortgage without coming up with the cash on your own by borrowing the minimum down payment. 

With this method, you would have to use a line of credit or your credit card to borrow the funds needed for a down payment. However, this can be a risky move, as you’ll be left with high-interest debt to pay back. 

What credit score do I need to get a mortgage in Canada?

The minimum credit score needed to get approved for a home loan in Canada is 640. However, you may be able to get away with a slightly lower score if you can find a lender who works with low credit borrowers. 

Final Thoughts

There’s no getting around a down payment when it comes time to take out a mortgage to buy a home. But you may be able to get approved with a smaller down payment without having to get slapped with a high-interest rate. Just keep in mind all the other fees that may come with a minimum down payment amount.