The loan-to-value ratio is a measurement used by financial institutions to determine the level of risk when extending a mortgage loan. When you buy a home, the LTV ratio expresses the monetary gap between your proposed mortgage and the appraised value of the property being purchased. Because the house and property secures a mortgage loan for the lender, a higher LTV ratio means a higher risk. A high LTV ratio can mean more costs for the buyer or a denied loan.
You need a LTV ratio of 80% for most conventional loans. This means you establish instant equity in your home with a down payment that covers 20% of the home’s value or purchase price. The primary exceptions to the 80% LTV ratio guideline are for buyers using certain government-backed loans, such as Federal Housing Administration loans or Veterans Administration loans.
What is the loan-to-value ratio?
While the loan-to-value ratio is used by lenders to judge the risk assumed with a loan, it also of value to borrowers beyond the qualification criteria. The percentage tells you how much equity you would have in the home at purchase. If you buy a home with a high LTV ratio, you limit the development of equity in your home and commit to paying a lot more in interest.
For starters, a high LTV ratio often means higher interest rates over the life of the loan and mortgage insurance is required. If you receive the loan, you are also financing a larger balance. In the first several years of a loan, the greater portion of your payments at the start are devoted to interest. Depending on the interest rate obtained on a 30-year mortgage, it can take several years or over a decade before the portion of your payments dedicated to interest and principal reach the same level.
Throughout this time period, you are relying on the housing market and other uncontrollable factors, such as improvements, to grow your home equity. If the market doesn’t comply, you could end up owing more than the home is worth in a downturn. This is part of what makes lenders averse to higher LTV ratios. In the event of a default, it can be difficult to recover the value of the initial loan.
How is loan-to-value ratio calculated?
The basic formula for calculating the loan-to-value ratio is mortgage total divided by appraised property value. The answer is expressed as a percentage. For example, an $80,000 mortgage on a home with an appraised property value of $100,000 is a perfect 80% LTV ratio fit. The $80,000 mortgage divided by $100,000 equals 0.80 or 80%. If you are paying the full appraised value for a home, you can then multiply the appraised value by 20% to arrive at the preferred down payment. In this example, it would be $100,000 multiplied by 0.20, or $20,000.
When you buy a home for less than appraised market value, you are reducing the loan-to-value ratio through careful negotiation. Unfortunately, this does not always mean a corresponding reduction in the required down payment. In most instances, a lender will use the lower of the appraised property value or purchase price when calculating the LTV ratio. However, you do retain the bonus of having even more equity in the home at purchase.
What impacts loan-to-value ratios?
Anything that adds or takes away equity from the home impacts the loan-to-value ratio. An increase or decrease in the amount of your mortgage based on down payments or price reductions provides equity. After you are in the home, you can add equity through improvement projects, consistent upkeep and renovations.
Positive changes in the housing market in your area also have the potential to greatly impact loan-to-value ratios. An upward trend in property values as you chip away at a mortgage is a win-win if you are eyeing a second mortgage, home equity line of credit or refinancing. When you move into a home with a higher LTV ratio, required mortgage insurance and a higher APR, refinancing after 20% or more equity develops can save you major money on interest and insurance premiums over time.
Loan-to-value versus combined loan-to-value ratio
The combined loan-to-value (CLTV) ratio goes beyond the basic LTV ratio to consider all loans that a home is used to secure. This can include a home equity line of credit and a second mortgage. To calculate the combined loan-to-value ratio, you add up all loans wherein the house is collateral and then divide by the appraised value. As a rule, 80% is still a maximum target for CLTV ratio when you want to secure good rates on new borrowing. However, there is greater flexibility on this measurement for most lenders when you have a high credit rating.
LTV and loan types
Guaranteed loan programs provided by the FHA and VA help qualifying buyers get into homes with lower or no down payments. The reduction of the down payment requirement increases the LTV ratio allowed.
For a basic FHA mortgage, you can obtain financing for up to 96.5% of a loan. This means the maximum LTV ratio is 96.5%, and the down payment requirement is 3.5%. An annual mortgage insurance premium is required, but the first year can be financed into the home purchase. In addition to accepting a higher LTV ratio, FHA loans are also available for consumers with credit scores lower than 600, making it an ideal option for borrowers with financial bumps in the past.
VA loans are a guaranteed loan option provided through the Veterans Administration. A VA loan does not require any down payment, meaning the maximum loan-to-value ratio is 100% on both new purchases and refinancing. Both VA loans and FHA loans are provided through many of the same financial institutions that offer conventional loans, making the loan types easy to explore as you research your options.
The bottom line
While you may not have heard the term loan-to-value ratio before, you were undoubtedly familiar with associated concepts like a 20% down payment. If you are considering a first home purchase or a new home purchase, the LTV ratio is an essential part of obtaining a mortgage. Whether you have a set amount of money dedicated to a home purchase or want to buy a specific home, assess your financial readiness. Do you have enough savings for a down payment? Do you have the credit rating necessary for a good interest rate? While you are looking for the home of your dreams, spend some time researching home mortgages and using tools like The Simple Dollar savings calculator to ensure that you’re ready for the purchase when the right home appears.