Your down payment plays an important role when you’re buying a home. A down payment is a percentage of your home’s purchase price that you pay up front when you close your home loan. Lenders often look at the down payment amount as your investment in the home. Not only will it affect how much you’ll need to borrow, it can also influence:
- Whether your lender will require you to pay for private mortgage insurance (PMI). Typically, you’ll need PMI if you put down less than 20% of the home’s purchase price.
- Your interest rate. Because your down payment represents your investment in the home, your lender will often offer you a lower rate if you can make a higher down payment.
So how much of a down payment will you need to make? That depends on the purchase price of your home and your loan program. Different loan programs require different percentages, usually ranging from 5% to 20%.
Loan-to-value ratio
The amount of your down payment helps give your lender the loan-to-value ratio (LTV) of the property. LTV is one of the main factors – along with debt-to-income-ratio and credit score – that a lender considers when deciding whether or not to extend you credit.
Your loan-to-value ratio indicates how much you will owe on the home after your down payment, and is expressed as a percentage that shows the ratio between your home’s unpaid principal and its appraised value. The higher your down payment, the lower your loan amount will be and the lower your loan-to-value ratio will be. Here’s the formula:
Loan amount ÷ appraisal value or purchase price (whichever is less) = loan-to-value (LTV)
For example:
- The home you want to buy has an appraised value of $205,000, but $200,000 is the purchase price
- The bank will base the loan amount on the $200,000 figure, because it’s the lower of the 2
- You have $40,000 for a down payment, so you need a $160,000 loan to meet the $200,000 purchase price
- Your loan-to-value equation would look like this: $160,000 ÷ $200,000 = .80
- You multiply .80 by 100% and that gives you an LTV of 80%
Private mortgage insurance (PMI)
If your down payment is lower than 20%, your loan-to-value ratio for conventional financing will be higher than 80%. In that case, your lender may require you to pay private mortgage insurance, because they’re lending you more money to purchase the home and increasing their potential risk of loss if the loan should go into default. Keep in mind that private mortgage insurance will increase your monthly payments.
When you consider how much to put down on your home, think about your lender’s requirements and what a higher or a lower down payment will mean for you. Is it worth it to you to pay private mortgage insurance each month in order to receive the other benefits of homeownership? Or would it make more sense for you to save for a larger down payment and avoid PMI, even if that means waiting longer to buy a home? Knowing the financial impact of each choice can help you make your decision with confidence.
If you’re having trouble saving for a down payment, you should know that certain lenders participate in programs that could enable you to qualify for down payment assistance. Ask your lender whether you might qualify for one of these programs.
