How Does a Down Payment Affect a Home Purchase?

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Once you find a home that you have fallen in love with, you will probably try to do the math immediately. There is a rule of thumb that tells you to calculate 20% of the loan to figure out your down payment.

down payment on a homeHowever, it will also depend on the type of loan. The down payment will affect how much your loan is, which will also affect the amount you pay as far as interest.

Loan and Value Ratio

Once you take out a loan, the lender will asses the loan to value ratio. This ratio is also called the LTV ratio, which is the assessment between the value of the home and the value of the loan.

For example, if you are buying a home that is $200,000 and you have $40,000 for a down payment, then you have saved 20% for the down payment. So in this specific case, the LTV ration will be 80%. The reason a lender looks at this is that the lower the ratio, the lower the lender’s risk for loaning to you.

Conventional Loans

The government does not back conventional loans, and it also requires the LTV ratio to be 80% or less. The borrower that has less than the 20% for a down payment may be approved for this type of loan, but only if the borrower agrees to pay for private mortgage insurance (PMI).

PMI is a monthly payment that is created to protect lenders if the loan goes into default until at which time the borrower reaches the minimum 20%.  Now that you know what this type of loan is, you will know that when someone is speaking of a 20% requirement, they are speaking of this type of loan.

Government Backed Loans

If you do not have the 20% for a down payment, then you will seek out a loan that is backed by the government. These loans are referred to as FHA loans and are backed by the Federal Housing Administration. Typically the down payment can be as small as 3.5%.

In the case previously stated of the home for $200,000, the down payment of 3.5% would be $7,000 for a down payment, leaving the LTV ratio at 96.5%. This process is considered extremely risky. In this situation, the borrower will be required to get PMI.

VA loans can also be used and backed by the Department of Veterans Affairs. These type of government loans are the only loans that do not require the borrower to have a down payment or PMI.

In conclusion, your down payment will affect which type of loan you will use to purchase your house. It is in your best interest to have as much of the amount saved as possible to lower the loan value, increasing your chances of securing a loan and not being required to pay out extra for PMI.

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Glenn S. Phillips is the CEO of Lake Homes Realty. He is also an author and speaker. When not thinking about real estate and technology, he periodically plays his ugly tuba (complete with a bullet hole), enjoys exploring cognitive thinking, and prefers dark chocolate.

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