Tuesday, March 4, 2008

Why Mortgage Lenders Care About Where Your Down Payment Comes From

When people are applying with me for a mortgage and I ask them where their down payment is coming from, they often give me a confused look. They don’t understand why their lender would care where their down payment comes from. After all, a down payment is a down payment. Who cares where it comes from? Actually, it matters a great deal where your down payment comes from.

The source of your down payment says a lot about the strength of your mortgage application. For example, if you have been able to save $50,000 for a down payment, it says something about how you handle money. All else being equal, a mortgage application with a down payment that comes from your savings is stronger than an application with a down payment that is a gift from a family member.

Lending institutions like banks and trust companies will ask to see proof of your down payment. If your down payment is from your savings, you will need to provide either 3-months bank statements or copies of investment certificates. If the down payment is a gift from a family member, a gift letter will need to be provided with the donors contact information.

In some cases it is a requirement of the mortgage that the down payment be from the borrowers own resources. For example, there is a mortgage product available for self employed people in Canada where proof of income is not a required, but it is a condition of the mortgage that the down payment – which must be at least 5% of the purchase price – come from the borrowers own resources. I guess they figure that if they are going to loan you that much money without proof of income, you should at least be able to show that you’ve been able to save the down payment!

Sometimes, people want to borrow their down payment. Why would anyone want to borrow funds for a down payment? The main reason is to avoid insurance premiums. In Canada, when your down payment is less than 20% of the purchase price, you must pay mortgage insurance premiums. Mortgage insurance premiums normally range between 1% - 3.1% of the mortgage amount. By increasing your down payment, you can reduce or avoid the insurance premium.

The disadvantage of borrowing funds for a down payment is that your ongoing monthly cost to service all your debts may become onerous. On a line of credit most institutions require 3% of the outstanding balance to be repaid monthly. It’s usually not worth borrowing your down payment but there are exceptions. I recently prequalified a buyer who had an unsecured credit line at prime. By drawing $50,000 on her line of credit she would save approximately $10,000 in insurance premiums. Since the rate on the credit line was attractive and since the line of credit payments were interest only in her case it made sense.