The loan-to-value ratio is a measure used by lenders to determine how much risk they’re taking on with a secured loan. It analyzes the relationship between the loan amount and the value of the underlying asset. To put it in simple terms, if a lender provides a loan worth half the value of the asset, then the LTV would be 50%. High LTVs are riskier for lenders because the more money owed on an asset, the higher the chance that the borrower will not be able to pay it back in full.
While loan value ratios apply to any secured loan, they are most commonly used in mortgages. This article will provide an overview of why LTVs are important and how they can affect the interest rate you pay on your home loan. We will also show you how to calculate the loan to value ratio.
How to Calculate LTV
Calculating the LTV is a relatively simple process. To figure out your LTV ratio, divide the loan amount by the appraised property value and multiply by 100 to get the percentage.
For example, if you’re buying a home with an appraised value of $400,000 and the loan amount is $300,000, the LTV ratio would be:
($300,000/$400,000) x 100 = 75%
This comes out to an LTV of 75%.
For the most part, lenders and federal housing regulators are typically concerned with LTV ratios right before a loan is issued. However, you can also calculate the LTV during the loan repayment period. Simply divide the remaining balance of your mortgage by the property’s appraised value.
Over time, as you repay your loan from month to month, the balance owed decreases, ultimately lowering the LTV. An increase in your home value can also lower the LTV. However, if the price of your property were to drop significantly, this could negatively affect your LTV, making it much higher than it was initially.
The worst thing that could happen to a borrower is having an LTV greater than 100%. Borrowers who reach that point are considered “underwater” on the loan, meaning the market value of their asset is less than the balance they owe. A loan to value ratio higher than 100% is also possible early on in the loan repayment period if the loan was issued with high fees and closing costs.
How Does LTV Affect Interest Rates?
U.S. lenders typically price their loans based on the risk profile of their borrowers by implementing what they call “risk-based pricing.” If a borrower is considered high risk, their loan will likely be categorized as risky and carry a higher interest rate.
Buyers with excellent credit can usually take advantage of low interest rate loans, whereas those with not-so-great credit will have to pay higher interest. Having gone over the fact that high LTVs are considered risky, it makes sense that loans with high LTVs usually carry higher interest rates.
However, it is important to note that higher interest rates aren’t the only downside when it comes to having a high LTV. Borrowers looking to buy a house with a conventional loan with an LTV ratio greater than 80% may require the borrower to obtain private mortgage insurance (PMI).
Lenders require PMI as a form of protection in case the borrower fails to repay the loan. In most cases, PMI costs can range between 0.5 to 1% of the loan balance every year and must be paid until the LTV ratio drops to below 78%.
What Is Considered a Good LTV?
For the most part, borrowers looking to take out a conventional loan will want to have a loan to value ratio of 80% or less. As was mentioned earlier, PMI is usually required for mortgages with LTV ratios greater than 80%. PMI could potentially add thousands of dollars to a borrower’s payments throughout their loan.
Note that, however, not all loans are the same. Those looking for a federally backed government loan can carry a higher LTV because these loans often require a lower down payment. For example, an FHA loan only requires a 3.5% down payment which would leave the borrower at an LTV ratio of 96.5%. Additionally, both the USDA and VA loans don’t require any down payment, making those loans carry a 100% LTV ratio.
Keep in mind that many federal loans will require a form of mortgage insurance or come with extra fees in closing costs to offset the risk associated with their high LTV ratios.
How to Lower Your Loan to Value Ratio
Borrowers can reduce their LTV by allocating more money toward the down payment. Having at least a 20% down payment can prevent you from having to get private mortgage insurance and also allow you to secure a better interest rate.
If the home you’re currently considering is a little out of your budget, it might make more sense for you to look at something a little more affordable, even if it isn’t your dream home. Finding a more affordable option will ensure that you have a manageable LTV. Keeping your LTV under 80% gives you the best chance to not overpay in interest and ensures that you can afford to pay back the loan.
Having gone over the ideal loan-to-value ratio on a mortgage, it has become clear that having an LTV over 80% can present challenges to a borrower. Keeping your LTV lower than that rate is critical if you want to avoid paying for PMI and any associated high fees. Luckily, there are solutions to keeping your LTV ratio low. These include putting more money down and finding a home that is more affordable to ensure that you will be able to make the monthly payment.