Several factors impact your mortgage rate when you buy a home. Lenders will consider your credit history, employment history, savings and assets, your income and your debt-to-income ratio.
Another important factor is your loan-to-value (LTV) ratio. This ratio expresses your total mortgage as a percentage of your home's purchase price. A higher LTV ratio means you have less home equity at the start of your loan, which translates into higher mortgage payments each month.
Calculating the Loan-to-Value Ratio
Calculating LTV ratio is easy. The simple way is to subtract your percentage down payment from 100%. Or you can divide your total mortgage loan by your home's purchase price.
For example, say you have an eye on a $200,000 home and can put 10% down, or $20,000. The mortgage would be $180,000, resulting in a loan-to-value ratio of 90%. That's $180,000 ÷ $200,000, or 100% – 10%.
A lower loan-to-value ratio is preferable. Conventional mortgage lenders typically provide better terms when LTVs are no higher than 80%.
Implications for Home Buyers
Many programs help home buyers if their down payment is less than 20%. The Federal Housing Administration (FHA) provides mortgage insurance on loans made by FHA-approved lenders. It will back loans for borrowers making a 3.5% down payment if they have a FICO score of at least 580. Borrowers with a score between 500 and 579 would need to put at least 10% down.
However, there are drawbacks to taking a mortgage with a high LTV ratio. To start, the monthly payment will be higher. This is due to higher principal payments, but also higher mortgage interest payments that lenders demand to compensate for the higher risk associated with the loan. Premiums for mortgage insurance also contribute to higher monthly costs. Borrowers with high LTV ratios are often required to pay for private mortgage insurance (PMI) until they reach 20% equity levels in their homes.
PMI is calculated each year as a percentage of the original loan amount. It ranges from 0.25% to 2% of the loan (depending on the LTV ratio and your credit score) and is added to the monthly mortgage payment. PMI costs can be substantial over time. Under the Homeowners Protection Act, borrowers can cancel their PMI premiums after achieving 20% home equity, and lenders are automatically required to cancel it once 22% has been achieved.