As most people know, the very first step in securing your mortgage is placing a down payment. A percentage of the property's worth which acts as a deposit between you and the lender, the down payment also provides buyers with their initial home equity. Despite seeming like a simple transaction, deciding how much to invest depends on a lot of factors. Working out how much you should spend on your down payment affects your whole future mortgage in ways I will explain here, in detail, allowing you to make the right decision and the best start possible with your mortgage.
Factors your down payment will affect include:
Your interest rate. Your interest rate will be lower if you can make a higher down payment, resulting in lower monthly payments.
Which type of loan you should take. How much you invest in your down payment will affect whether a fixed rate mortgage (FRM) or adjustable rate mortgage (ARM) is right for you. If you're stretched to make a large down payment then an adjustable rate mortgage with lower initial monthly payments may be beneficial, but for more information on the pros and cons of FRM's and ARM's, brush up with this article here to understand the different mortgage types.
Whether you have to pay PMI. PMI stands for private mortgage insurance, and typically applies to those who pay less than 20% of their property's value as a down payment. Borrowers who are required to pay this are deemed as a bigger potential risk because the company is lending them more money, a potential loss if the mortgage goes into default. Essentially those who are paying less than 20% of the home's value as a down payment have a LTV ratio of higher than 80%, making their case less desirable to lenders (LTV is explained here, below).
Loan To Value Ratio. In mortgages this is a term used to express the ratio of a loan to the value of the property purchased, i.e. how much you have left to pay after your down payment. This is one of the main factors, along with credit score rating and debt to income ratio, which lenders take into account when considering extending your credit. The higher your down payment, the lower your loan and LTV ratio will be.
To work out your LTV ratio, divide your loan amount by the appraisal value or purchase value of your property (whichever is lower) and multiple by 100.
For example: I want to buy a home with an appraised value of $305,000, purchase price $300,000. I invest a down payment of $50,000. This leaves $250,000 left to meet the purchase price. $250,000 divided by $300,000 is 0.83 multiplied by 100 = 83%.
As you can see, making the right choice on your down payment affects a lot more than just how much you initially have in your pocket. Deciding whether it's worth investing in a larger down payment to get lower monthly payments without the added cost of PMI can be hard if you're in a rush, but sometimes may be the more sensible financial option.