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What's more important when applying for a mortgage: excellent credit or 20% down payment?

CNBC Select spoke with a loan officer who explained why the size of your down payment is just as important as your credit score in getting an affordable mortgage.

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Buying a new home involves lots of decisions for both the buyers and the mortgage lenders — and it all begins with financing.

Your main focus when buying a home should be securing a mortgage with low interest rates and a monthly payment that fits into your budget. To make it easier, experts recommend cleaning up your credit report and boosting your credit score before applying for a mortgage and saving up for a considerable down payment. 

But it's not always clear how big your down payment should be. Traditionally, homebuyers hear they must be able to put 20% down, but depending on where you live and what kind of mortgage you get, you might not need that much.

Yet there's still one major reason why experts recommend putting 20% down whenever you take out a conventional mortgage, according to Movement Mortgage loan officer Heidi Gage. This amount is the minimum requirement to avoid paying private mortgage insurance (PMI) — an extra premium that's tacked onto your monthly mortgage to protect the lending company in case you default.

Below, we spoke with Gage to learn why you should consider putting down a larger down payment in addition to improving your credit score before applying for a mortgage. Gage also shares how mortgage lenders make their decisions so you know how much you should save when planning to buy a home.

Why the down payment matters just as much as your credit score

A 20% down payment saves you from paying PMI on a conventional mortgage.

The Consumer Financial Protection Bureau (CFPB) warns that PMI is meant to protect the lender — not the buyer. From a lending perspective, a buyer who doesn't put 20% toward their home puts more liability on the mortgage company since they are borrowing more money.

And unlike your mortgage bill, your monthly PMI payment never goes toward paying off the cost of your home. This means you'll be paying more money each month but not getting any closer to paying your house off. 

Another helpful reason to save up for a larger down payment is to influence the size of your mortgage: "In essence, a bigger down payment may allow you to buy a higher priced home," Gage tells CNBC Select.

The more equity you have in a home, the lower the risk for default.  This lower risk can then translate into a more favorable rate for the borrower. 

How lenders decide who gets a mortgage

Gage explains that there are four main factors that mortgage lenders consider when you apply for a home loan — she calls them the "four Cs."

They are 1) credit history and score; 2) collateral (type of property being secured); 3) cash (your down payment) and 4) capacity (how much debt you have versus income every month).

"Underwriters review the loan based on the above criteria, as well as layered risk factors," explains Gage. If you have low capacity (meaning your debts are high and your income is stretched too thin), you could be denied a mortgage if you don't have a big enough down payment. And on the other hand, a risky debt-to-income ratio can be overcome if a borrower has a lot of cash in the bank and stellar credit history, says Gage.

"This is why it is vital to be pre-approved before going house shopping," advises Gage. "An experienced loan officer will review credit with a potential borrower and oftentimes can provide them a 'road map' for better credit via tools the loan officer has access to."

For instance, Movement Mortgage loan officers can assist the buyers in improving their scores, including a "what if" credit simulator that shows borrowers what actions they can take to improve their credit score in order to get the most affordable rates (such as pay down credit cards and loans, establish new credit, etc.) 

And if you have been putting money into savings, Gage recommends reserving some of your cash in an emergency fund separate from your down payment fund. Mortgage underwriters call this cash your "reserves," and they prefer to see that you have enough to cover home repairs, property taxes, homeowners insurance and unexpected emergencies well after your closing date. 

"How much a borrower keeps in reserves versus how much they put down is something they need to decide upon as an individual based on their budget and personal comfort level," says Gage.

What to do if you can't put 20% down

Making a 20% down payment follows conventional wisdom, but in many markets there are flexible mortgage options that require as little as 3% down, Gage explains.  

Traditional mortgage products offer lower down payment loans, as well as special programs for first time buyers.  Some examples are VA and USDA loans (up to 100% financing), FHA offers (requires 3.5% down) and Fannie Mae and Freddie Mac (as little as 3% down). As a buyer, you should discuss the pros and cons of each with your lender.

In fact, the average first-time home buyer in 2019 only put 6% down on their home, financing 94% of the purchase price. That's compared to repeat buyers' average down payment of 16%, according to latest data from the National Association of Realtors (NAR)

"More often than not, buyers put 20% down on subsequent home purchases using the equity from the sale of another property," says Gage.

Last year, 38% percent of home buyers said they used proceeds from the sale of a primary residence to secure a down payment on their next one.

Bottom line

"The closer a borrower comes to 20% down, the lower their monthly payments will be," says Gage.

A large down payment factors into your borrower profile when you apply for a mortgage, along with your credit history, collateral and current debt load.

If 20% seems daunting, like it does for many first-time homebuyers, there are options for buying a home with less cash upfront. If buying real estate is important to you and your financial plan, consider whether it's worth paying a monthly premium for PMI.

As you prepare to apply for a mortgage, reach out to qualified loan officers and ask for assistance in building up your credit score and improving your approval odds.

Don't miss: What credit score is required to buy a house?

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.
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