Home buyers with smaller down payments often receive lower interest rates, which may seem counterintuitive. In this article, we will explore the reasons behind this and why borrowers with a 5%, 10% or 15% down payment can secure this lower rate compared to those with a 20%+ down payment.
All About Loan-To-Value LTV
A high-ratio mortgage is when the loan equals or exceeds 80% of the home value, otherwise known as the Loan-to-Value or LTV. In a purchasing scenario, this is a down payment of 19.99% or less. These mortgages require mortgage default insurance because there is little equity to secure the loan.
For example, these high-ratio/insured mortgages can obtain a 5-year fixed-rate mortgage at 5.09%*. In contrast, uninsured mortgages, where the loan-to-value is under 80%, may start with quotes at 5.34%.
Understanding Lower Interest Rates And Low Down Payments
To better understand this discrepancy, we must recognize the role of mortgage insurance. Borrowers with less than a 20% down payment must qualify for mortgage default insurance in addition to the lender’s mortgage qualification.
Mortgage default insurance, commonly known as CMHC insurance, is provided through 3 insurance providers: Canada Mortgage Housing Corporation (CMHC), Sagen and Canada Guaranty. This insurance protects lenders in case of borrower default, mitigating repayment risk.
The Role Of Mortgage Insurance
Mortgage insurance ensures that lenders receive payment even if the borrower defaults. By reducing default, lenders can offer lower interest rates to high-ratio borrowers. Mortgage insurance is a safety net for lenders, making high-ratio mortgages less risky.
Borrowers with less than a 20% down payment face a premium for the required insurance.
For example, if a buyer purchases a home for $500,000 and puts down 5% ($25,000), the required mortgage is $475,000. The one-time insurance premium for this purchase would be 4% of the mortgage equaling $20,000. This amount is added to the mortgage loan, resulting in a starting mortgage balance of $495,000 against a property.
Calculating the Cost of Insurance Premiums
In addition to the one-time insurance cost, borrowers pay interest on the premium over the amortization of the mortgage loan, the same as the mortgage itself.
To illustrate its actual cost, let’s take the $500,000 purchase example using the insured 5.09% 5-year fixed interest rate over a 25-year amortization. The one-time premium of $20,000 with compound interest totals $35,390.74. That is $15,390.74 in additional interest.
Considering this cost, let’s revisit the rate discrepancy. In the earlier example, the high-ratio 5-year fixed rate was quoted at 5.09%, while the latter at 5.34%. While the lower rate would be the better option, this is not the case. Because of the additional one-time premium and its accrued interest, the cost of borrowing is higher even with a 0.25% or 25 basis point spread.
To Insure Or Not Insure
Now that we know its cost, what are the benefits and value to the borrower? Its primary use and design allow prospective home buyers to purchase a home with a low down payment. After all, the down payment is, if not the most significant hurdle to home ownership. Coverage also makes the mortgage more attractive to lenders. Lenders may be more likely to approve a mortgage if default insurance is behind it.
Insurance for Non-High Ratio Mortgages
Some mortgages can be insured even if they are not considered high-ratio. One scenario being self-employed borrowers who cannot verify their income through traditional means may have their mortgages insured based on alternative evaluation criteria.
Mortgage Insurance and Refinancing
Mortgage refinancing can no longer be insured, leading to higher interest rates due to the higher default risk for lenders.
Due to the absence of mortgage insurance, refinancing poses a higher risk for lenders, leading to a higher rate structure. Although the risk of default is typically small among Canadian borrowers, it influences the interest rates offered for those who refinance.
Consider Reading: Benefits of a Well-Planned Down Payment Strategy
The discrepancy in interest rates between borrowers with smaller down payments and those with larger down payments can be attributed to mortgage insurance. Lenders protect themselves against default risk by obtaining insurance coverage, making high-ratio mortgages less risky.
Borrowers should consider the impact of insurance premiums and evaluate their down payment options accordingly. Understanding the dynamics of mortgage insurance helps borrowers make informed decisions when navigating the mortgage market.