NEW YORK (MainStreet) — First-time homeowners are often caught in a conundrum when they are faced with tantalizing offers of either lower mortgage rates or a smaller down payment.

The decision is much harder to make than it appears because of many variables such as the stability of your profession, the likelihood of buying another home within a few years and the long-term costs of higher payments.

While at first glance paying a smaller down payment sounds like the obvious choice for many Millennials and Gen X-ers who want to own a home, but are also saddled with student loans and credit card debt, the decision has other ramifications. A higher mortgage rate means paying thousands of extra dollars in interest alone over time.

A recent study conducted by the Federal Reserve Bank of New York found that when a lower down payment is required, it affects the demand on housing more as additional consumers are eager or able financially to purchase a house. Changes in the mortgage rate have a “modest” effect, wrote Andreas Fuster and Basit Zafar, both senior economists at the Federal Reserve Bank of New York’s research and statistics group. The study asked 1,000 households what would affect their willingness to buy a home if they were to move to a similar city and a comparable home.

When the households were offered either a 20% down payment compared to a 5% down payment, the number of people willing to pay for a house rose by 15% when the lower amount was an option.

The lower down payment amount is more appealing to renters, who are likely to be first time homebuyers, because their willingness to buy increased by over 40%, the study found. Out of the renters, 50% chose the smaller down payment compared to 36% of current homeowners.

“Even just looking at owners, the reaction is stronger for those with lower current (housing and non-housing) wealth, lower income and lower credit scores,” Fuster and Zafar wrote in their research paper. “This finding is important since it suggests that liquidity constraints play a substantial role in individuals’ willingness and ability to pay for a home.”

The study also examined a scenario where either a 6.5% or 4.5% mortgage rate was offered. Consumers are not as influenced by lower rates, and their willingness to purchase a home was only reduced by 5% when they were offered the higher rate.

“The mortgage rate may play a less important role than commonly thought,” the authors wrote.

Depending on your current income, credit score and the amount you have saved for a down payment, either the lower upfront cost or interest you will pay for the next 30 years, will be more appealing and play a larger factor in your decision making.

Pros of a Lower Down Payment

Most homebuyers should opt for a lower down payment over a lower interest rate, said Tim Lucas, editor of, a Bellevue, Wash. mortgage website for consumers.

“When you buy a home, you agree to make that payment for 30 years, come hell or high water,” he said. “If you lose your job or have a medical emergency, you need a war chest stashed somewhere to weather the storm.”

Allocating the majority of your savings to make the maximum down payment could result having a homeowner lose both his down payment and home if there is a downturn in the economy and he is not able to make mortgage payments.

“In today's lending environment, even a ‘high rate’ is about 3% below average rates over the past 40 years,” Lucas said. “Someone who chooses a low down payment mortgage program will still get a pretty sweet rate.”

A lower down payment means homeowners have to shell out extra money by paying private mortgage insurance (PMI), which is often another $100 or $200 a month.

“Before making the decision in favor of a low down payment, be sure you know what the mortgage will cost you,” said Mary Blanchard, a vice president with PrivatePlus Mortgage, an Atlanta-based mortgage company. “Putting less money down may mean you pay a higher interest rate, you may have a higher monthly payment and it might necessitate your having PMI.”

Consumers who are purchasing their first home and have a good credit score often do not have to put the traditional 20% down payment for the house, she said.

“A lower down payment can encourage some buyers in certain buying scenarios,” Blanchard said. “A lower down payment may enable them to buy and still have a lower rate, which is typically within a half point of the rate they would get with a larger down payment.”

Advantages of Lower Interest Rates

While a lower down payment might be more appealing for a first time homebuyer, it can often result in paying more money just on the interest alone, said David Reiss, a law professor at Brooklyn Law School in N.Y. Lenders offer mortgage rates largely based on the credit score of the homeowner, so a cheaper interest rate may not always be available.

Let's say the homebuyer is considering a $100,000 property that is paid for with a $90,000 interest-only mortgage with a 4% interest rate and a $10,000 down payment or with a $95,000 interest-only mortgage with a 5% interest rate and a $5,000 down payment.

The first mortgage means the consumer would pay $3,600 a year in interest. However, the second mortgage results in the consumer paying $4,750 a year in interest.

“That is not an apples-to-apples comparison, because the second mortgage interest payment reflects the higher loan to value ratio and the higher interest rate and it also does not take into account the tax treatment of interest payments,” he said.

Homeowners need to decide if paying additional money in interest is “worth it,” since a consumer would pay about $1,000 a year more in interest for the “privilege of paying the lower down payment,” Reiss said.

“I think that it is smart to figure out how to pay as low of an interest rate as possible, given the other financial constraints you face,” he said.

Many consumers believe there is not much of a difference between a 3.5% or 4% mortgage rate, but it can result in another few hundred dollars each month in mortgage payments, which can add up easily in 30 years.

“That is real money,” Reiss said. “You want to do everything you can to get the interest rate down, especially in today’s low interest rate environment.”

Refinancing a mortgage in the current market conditions means your rate is not likely to decline much, so receiving a lower rate now will have a larger impact over the next 30 years, he said. After paying closing costs, many homeowners do not see the impact of the lower rates until the fourth year after the refinancing occurred.

“Since refinancing requires a large upfront cost of thousands of dollars, you need to live there long enough for it to make sense if you are only saving less than 1% on your mortgage rate,” he said.

Although a consumer would have less savings by putting down a larger down payment, there are few cons to having a lower payment since they would have “more skin in the game,” said Tony Sachs, chief lending officer at Sindeo, a San Francisco mortgage marketplace.

Beyond examining the mortgage rate and down payment, potential homebuyers need to also factor in paying for insurance and property taxes.

“Most people are very rate sensitive and tend not to think about other costs associated with home ownership,” Blanchard said. “It is crucial to look at the big picture -- not only the entire mortgage scenario, but also home ownership costs beyond the purchase and mortgage from utilities to maintenance and so on.”