What Is Loan-to-Value Ratio?
Loan-to-value (LTV) ratio is a common tool lenders use to assess the risk of a loan. The LTV ratio of a loan is basically the size of the mortgage balance as a comparison to the underlying property value. Your LTV ratio is crucial when buying a loan as it can determine whether you will be approved and whether you need to buy mortgage insurance. Your loan-to-value ratio will also be important if you ever want to access your home equity with a loan or line of credit or you decide to refinance your mortgage.
Here’s how your loan-to-value ratio is calculated and when it’s used.
Calculating Loan-to-Value Ratio
The LTV ratio is the ratio between your loan amount and your home’s value, or its purchase price. To calculate the LTV ratio, divide your loan amount by the purchase price or home’s appraised value. For example, if you are buying a $150,000 home with a $30,000 down payment, your loan amount will be $120,000. This gives you an LTV ratio of 80%.
Why It Matters
Lenders place a great deal of weight on an applicant’s loan-to-value ratio when underwriting a loan. The lower the LTV ratio, the lower the interest rates for which you can qualify. This is because you are viewed as a better risk.
Lenders do not want to take your home; they want to be paid back on time and as quickly as possible. The lower the LTV ratio, the greater the amount of equity you have in your home. This reduces the risk that you will default on the mortgage. If you do default and the lender needs to foreclosure, they will be better able to recover the amount of the loan.
It isn’t just during a loan application that LTV ratio is used; this important factor is also considered if you want to refinance or take out a home equity loan or HELOC.
LTV Ratio and PMI
If you are applying for a conventional mortgage, your LTV determines whether you must pay private mortgage insurance (PMI). PMI is a type of insurance that protects the lender if you default on your loan. It can add more than $100 to your monthly mortgage payment. With conventional loans, you must put down at least 20% to avoid PMI, which gives you an LTV ratio of 80% or lower.
LTV Ratio and Home Equity Loans
The size of your down payment when you buy a home directly lowers your LTV ratio. Your LTV ratio can also change for better or worse with changes in the value of real estate in your area. As your home increases in value, you will gain home equity and lower your loan-to-value ratio. Making mortgage payments also steadily decreases your LTV ratio.
When you decide it’s time to access your home equity, your LTV ratio will again be considered.
Lenders usually use a metric called a closed loan-to-value (CLTV) ratio when you refinance. Your CLTV is the balance of your current mortgage plus your desired equity loan divided by the value of your home. You may be able to borrow up to a CLTV of 90% to 95%, but most lenders require a CLTV of 85% or less.
Loan-to-Value Ratio and Refinancing
LTV is an important factor in determining if you can refinance your mortgage and how much you will pay in fees and interest. While it is possible to refinance with just 5% equity, doing so can be expensive. If your LTV ratio is at least 80%, lenders will typically waive mortgage insurance and offer better interest rates and terms.
Your LTV ratio isn’t everything as your credit score, income, and other assets will also be big factors in determining whether you qualify for a loan and how much you will pay. Still, it’s important to keep your LTV ratio as low as possible to reduce your borrowing costs and keep other options open in the future.