What is a Loan-to-Value Ratio?

Loan to value ratio

The LTV (loan-to-value) ratio is a financial measure that compares the size of the home loan to the value of an asset purchased with the loan’s proceeds. Financial companies and lenders examine the LTV ratio to determine the risk associated with the home loans before approving any mortgage. Typically, loans with high LTV ratios are considered higher-risk loans. Therefore, the interest rate will be higher if the mortgage is approved.

A loan with a high LTV ratio may also require the borrower to purchase mortgage insurance to help offset the lender’s risk. This type of insurance is known as private mortgage insurance (PMI).  

How to Calculate the Loan-to-Value Ratio

Homebuyers can quickly calculate the LTV ratio of a property by using the following formula:

LTV ratio = MA

APV

Where:

MA = Mortgage Amount

APV = Appraised Property Value

The LTV ratio is calculated by dividing the loan amount by the property’s appraised value, expressed as a percentage. For example, assume you purchase a house appraised at $100,000 and put down a payment of $10,000. In such a case, you will owe $90,000. It results in the LTV ratio of 90 percent (i.e., 90,000/100,000).

Estimation of an LTV ratio is an essential part of mortgage underwriting. It can be used to finance the purchase of a home, refinance an existing mortgage into a new one, or borrow against a property’s equity.

Lenders use the LTV ratio to determine how much risk they’re taking when underwriting the home mortgages. Lenders believe borrowers who request a loan for an amount close to or equal to the appraised value (and thus have a higher LTV ratio) are more leveraged. This is because the property has very little equity. As a result, if a foreclosure occurs, the lender may find it challenging to sell the home for enough to cover the outstanding loan balance while still making a profit. 

The essential factors that affect the LTV ratio are the amount of initial deposit, sales price, and the property’s appraised value. Thus, the lower sales prices and higher down payments result in the lowest LTV ratio.

How Lenders Use the LTV Ratio

An LTV ratio is just one factor to be considered when applying for a mortgage, a home equity loan, or a line of credit. Nevertheless, it will significantly impact the interest rate that a borrower can secure. 

Most financiers offer the lowest possible interest rate on a mortgage or home equity loan when the borrower’s LTV ratio is at or below 80%. Borrowers with a higher LTV ratio are still eligible for a mortgage, though the interest rate on loans may grow as the LTV ratio increases. For example, a borrower with a 95 percent LTV ratio might get approved for a home mortgage. On the other hand, their interest rate could be a total percentage higher than the rate offered to a borrower with an LTV ratio of 75%. 

Borrowers who have a loan-to-value ratio of more than 80% may be required to purchase private mortgage insurance (PMI). This can add anywhere from 0.5 percent to 1 percent to the total loan amount annually. For example, PMI at 1% on a $100,000 loan would add $1,000 to the total cost paid per year (or $83.33 per month). PMI is required until the LTV ratio reaches 80% or less. The LTV ratio will decrease as you start paying your loan, and the value of your home increases over time. 

Typically, the lower the LTV ratio, the greater the chances that the loan will get approved, and the lower the mortgage rate is likely to be. Furthermore, you are less likely to be required to purchase a PMI (private mortgage insurance). 

While it’s not a law that lenders will require borrowers to have an LTV ratio of 80 percent or higher to avoid paying PMI. Borrowers with a high income, low debt, or a large investment portfolio may be exempt from this requirement.

Example of Loan-to-Value Ratio

Assume you buy a property that appraises for $100,000. The owner, however, is willing to sell it for $90,000. If you put a down payment of $10,000. Your loan will get approved for $80,000, resulting in an LTV ratio of 80 percent (i.e., 80,000/100,000). If you increase your down payment to $15,000, your mortgage loan would be $75,000. This will make your loan-to-value ratio 75% (i.e., 75,000/100,000). 

How can You Reduce Your Loan-to-Value Ratio?

Typically, reducing your LTV on home loans, especially mortgage loans, means lower total costs over the loan’s entire life. Because only two variables determine the LTV ratio—the loan amount and the asset value—the methods for reducing LTV are pretty straightforward: 

i) Increase your down payment

Saving for a large down payment may test your patience if you’re eager to get into a car or house. But it’ll be worth it in the end. 

ii) Set your sights on less expensive targets

Buying a house that is a little older or smaller than the home of your dreams may allow you to use more of your current savings to cover the purchase price.

Whether you’re applying for a home mortgage or auto loan, it’s essential to understand how your LTV ratio affects overall interest rates, what you can do to reduce LTV value, and how doing so can help you save money over the entire loan term. 

What is a Good Loan-to-Value Ratio for Refinancing?   

The general rule of thumb is that your LTV ratio should be no more than 80% when it comes to refinancing. This indicates that you have at least 20% equity in your home.

However, you may refinance your home with a higher ratio if you have an excellent credit score. But if you refinance into a conventional mortgage with a higher LTV ratio, you’ll still need to pay private mortgage insurance. Your lender will certainly charge you a higher interest rate.  

The LTV ratio requirements are less stringent when you refinance into a government-backed mortgage, such as an FHA, USDA, or VA home loan. Your LTV value can be as high as 96.5 percent for FHA loans. And you can remortgage with no equity in your home with a USDA or VA loan. Note that lenders consider more than just your LTV ratio when deciding whether or not to approve your refinance application. For example, you may officially be able to refinance into a USDA loan with a high LTV ratio. But a lender may still dismiss your application if you have a poor credit score.

Variations to Loan-to-Value Ratio Rules

Different types of loans may have additional requirements for LTV ratios.

FHA (Federal Housing Administration) loans

FHA loans are mortgages that are designed specifically for borrowers with low-to-moderate income. They are issued by the FHA-approved lender and guaranteed by the Federal Housing Administration. FHA loans require a lower credit score and minimum down payment than traditional home loans. Moreover, FHA loans are available at an initial LTV ratio of up to 96.5 percent. Still, you need to pay a mortgage insurance premium (MIP) for the life of the loan (no matter how low the LTV ratio eventually goes). Many people choose to refinance their FHA loans once their LTV ratio reaches 80% to avoid paying the MIP.

USDA and VA Loans

USDA and VA loans are available to current and former military officers or families living in backward areas. They don’t require private mortgage insurance, even though the LTV ratio can be as high as 100%. Nonetheless, both USDA and VA loans do have additional fees. 

Freddie Mac and Fannie Mae 

Freddie Mac’s and Fannie Mae’s home mortgage programs are developed for low-income borrowers. These loans accept a loan-to-value ratio of 97%. However, they require mortgage insurance until the debt-to-income value falls below 80%. 

A wide range of streamlined refinancing options is available for FHA, VA, and USDA loans. These loans waive the appraisal requirement, so the home’s LTV ratio does not impact the loan options. For borrowers with an LTV ratio of over 100%, also known as being “upside-down” or “underwater,” Freddie Mac’s Enhanced Relief Refinance and Fannie Mae’s High Loan-to-Value Refinance options are also available. 

LTV vs. CLTV (Combined LTV)

While the LTV ratio oversees the impact of a single mortgage loan when purchasing a property, the combined loan-to-value (CLTV) value is the ratio of all bank loans on a property to the property’s value. In addition to the primary mortgage used in LTV, it includes secondary mortgages, HELOC, or other liens. Lenders use the CLTV ratio to determine the risk of default for a prospective home buyer when more than one loan is used, i.e., mortgage along with a home equity loan or line of credit. Lenders are more likely to offer loans to borrowers with good credit scores and CLTV ratios of 80% or higher. Primary creditors tend to be more lenient with CLTV requirements since it is a more specific measure.

Let’s take a closer look at the differences. The LTV ratio only considers the primary mortgage balance on a property. Thus, if the principal balance is $100,000 and the property value is $200,000, the LTV ratio is equal to 50%.  

Consider the situation where it has a second mortgage of $30,000 and an HELOC of $20,000. The combined loan to value is now ($100,000 + $30,000 + $20,000 / $200,000) = 75%, which is a significantly higher ratio.

These factors are essential if the mortgagee defaults and the property undergo foreclosure. 

Disadvantages of Loan-to-Value (LTV) Ratio

The main disadvantage of the data that an LTV provides is that it only considers the primary mortgage that a homeowner owes and ignores other debts that the borrower may have, such as a second mortgage or a home equity loan. Therefore, the CLTV is a more comprehensive indicator of a debtor’s ability to repay a mortgage.  

Conclusion

Experts believe that even if you have the cash to purchase the property in one go, it’s always better to take out mortgage loans. Instead of paying a lump sum for the property, it is preferable to make a large initial deposit and pay off the remaining balance in higher monthly EMIs if you can afford it. One option to find the best home mortgage loans is Ratechecker.com. Visit our website to learn more about our mortgage products and services.