Several factors affect the mortgage rate you can obtain when you purchase a home. Lenders analyze credit histories and scores of all borrowers listed on the mortgage application, length and stability of your employment, the amount of your savings set aside, your total monthly income, and your debt to income ratio. In addition to these important aspects of financial health, mortgage lenders also take into consideration your loan-to-value ratio. This calculation represents the amount of the purchase price for the new home that is covered by a mortgage loan as a percentage. A higher loan to value ratio results in less equity ownership in your home, which creates higher mortgage payments each month.
Calculating the Loan-to-Value Ratio
Home buyers can easily calculate the loan-to-value ratio on their home by dividing the total mortgage loan amount into the total purchase price of the home. For instance, a home with a purchase price of $200,000 and a total mortgage loan for $180,000 results in a loan-to-value ratio of 90%. Conventional mortgage lenders often provide better loan terms to borrowers who have loan-to-value ratios no higher than 80%.
Implications for Home Buyers
There are many programs available to home buyers that allow for a down payment that is less than the traditionally recommended 20%. Mortgage loan providers, including the Federal Housing Administration (FHA), offer home loans with as little as 3.5% down payment, while other lenders have options for borrowers that have up to a 5% contribution. Although these programs are beneficial to buyers who are unable to save enough for a large down payment, these borrowing options result in a much higher loan to value ratio, which results in greater costs.
A high loan-to-value ratio occurs when borrowers have less than 20% equity in their homes, resulting in higher mortgage payments over the duration of a mortgage loan. This is due, in part, to increased interest rates assessed by mortgage lenders. A borrower who has less equity in his home is perceived to be a greater risk to the lender, and a higher interest rate can mitigate that risk. In addition to costlier interest rates, home buyers with high loan-to-value ratios are often required to pay mortgage insurance premiums until they have reached greater equity ownership stakes.
Mortgage insurance referred to as private mortgage insurance (PMI) for non-government mortgage lenders, is calculated as a percentage of the original loan amount each year. This charge ranges from 0.3% to 1.15% depending on the size of the down payment and the total purchase price, and it is added on to the mortgage payment each month. When combined with a higher interest rate, PMI can be a substantial cost for borrowers over time. Borrowers can request cancellation of the PMI premium when they reach 20% equity ownership, and lenders are required to cancel it once the loan-to-value ratio of the home reaches 22%.