Loan-to-value (LTV) ratio compares the amount of a mortgage loan to the property's market value. Mortgage lenders often use LTV when deciding whether or not to approve a potential borrower for a loan. Here is what you need to know if you're applying to buy a home or refinance one.
Key Takeaways
- The loan-to-value (LTV) ratio compares the size of your mortgage to how much your home is worth.
- Lenders prefer a low LTV ratio and are likely to charge you a higher interest rate if your LTV ratio exceeds a certain percentage.
- There are ways to lower your LTV ratio when you buy a home or after you have owned one for a while.
What Is a Loan-to-Value (LTV) Ratio?
When you're applying for a mortgage, the lender will typically compute a loan-to-value (LTV) ratio, comparing the amount of the mortgage to the home's purchase price, expressed as a percentage. The smaller your down payment and the more you borrow, the higher the LTV ratio.
In the case of a home that you have owned for a while, the LTV ratio will compare your current mortgage balance to the home's current appraised value. This can be important if you are planning to refinance your mortgage.
Note
Your loan-to-value (LTV) ratio is one of several factors that lenders may take into account in evaluating a loan application. Lenders will also consider your credit score, employment history, savings and assets, income, and debt-to-income (DTI) ratio.
LTV Ratio Formula
The formula for an LTV ratio is the dollar amount of your loan divided by the value of the asset—in this case, a home.
Calculating the LTV Ratio
Calculating your LTV ratio is straightforward.
For example, say you're looking to buy a new home. You have your eye on a $300,000 house and can afford to put 10% down, or $30,000. The mortgage would be $270,000, resulting in an LTV ratio of 90%. That’s $270,000 ÷ $300,000.
Another way to arrive at the same result is to subtract the percentage rate of your down payment from 100%. In the example above, your LTV ratio would be 100% - 10%, or 90%.
A lower LTV ratio is preferable for several reasons. Most importantly, from a financial perspective, mortgage lenders typically provide better terms when LTV ratios are no higher than 80% (meaning a down payment of at least 20%). What's more, putting more money down increases your equity in the home, which can come in handy if you ever want to refinance your home or borrow against it by taking out a home equity loan.
If you put down less than 20% for a down payment when purchasing a home, you'll typically have to buy private mortgage insurance (PMI). PMI premiums are paid monthly along with your mortgage payment.
How to Lower Your LTV Ratio
If you're buying a home, you can lower your LTV ratio by making as large a down payment as you can reasonably afford. (Bear in mind that you could also face substantial closing costs that you'll need to cover.)
If you already own a home, you have a few options for lowering your LTV ratio. For starters, each monthly mortgage payment that you make will lower your LTV slightly, as your loan balance gradually decreases. At the same time, if your home appreciates in value, as is often the case, that will also reduce your LTV ratio.
A more aggressive approach to lowering your LTV ratio is to make additional principal payments each month or whenever you have the cash to spare. That will reduce your LTV ratio and allow you to pay off your mortgage sooner, saving you money in total interest. This tactic is often referred to as making accelerated payments.
How LTV Ratio Affects Mortgage Payments
Your LTV can impact the size of your monthly payment, and a low LTV can lead to additional costs.
LTV and the Down Payment
While a 20% down payment may be ideal from a lender's point of view, many home buyers have a hard time scraping up that much cash.
Fortunately, there are programs available to help home buyers who can't afford a 20% down payment. For example, the Federal Housing Administration (FHA) insures loans made by FHA-approved private lenders to borrowers who put down as little as 3.5%.
However, to qualify for a 3.5% down payment on an FHA loan, the borrower must have a FICO credit score of at least 580. Borrowers with a score from 500 to 579 need to put at least 10% down, and those with scores under 500 are not eligible for the program.
The U.S. Department of Veterans Affairs (VA) backs 0% down VA loans for active service members and eligible veterans of the armed forces, provided that the home's sale price is no higher than its appraised value.
The Added Costs of High LTV Ratios
However, there are drawbacks to taking a mortgage with a high LTV ratio. For starters, the monthly payment will be higher. This is due to both the higher principal payments and the higher interest rate that a lender is likely to charge, based on the perception that a higher LTV ratio equates with a greater risk of the borrower defaulting on the loan.
In addition, borrowers with high LTV ratios are often required to purchase private mortgage insurance (PMI) and continue paying it until the equity in their home reaches 20%.
PMI is calculated each year as a percentage of the original loan amount. PMI costs range from 0.25% to 2% of the loan (depending on the LTV ratio and your credit score) and are added to the monthly mortgage payment. Over time, PMI costs can be substantial. Under the Homeowners Protection Act of 1998, borrowers can cancel their PMI coverage after achieving 20% home equity, and lenders are automatically required to cancel it once equity hits 22%.
What Is a Good LTV for a Mortgage?
Typically, mortgage lenders like to see a loan-to-value ratio (LTV) of 80% or less, which means you have at least 20% equity in the home.
How Do I Calculate the Loan-to-Value Ratio?
To calculate LTV, divide the mortgage loan amount by the home's appraised value. For example, if you're purchasing a $300,000 home with a down payment of $60,000, your mortgage loan would be $240,000. Your LTV would be 80% ($240,000 ÷ $300,000).
Why Is a High LTV More Risky?
High LTV ratios make borrowers appear more risky to mortgage lenders, who might not recoup enough money to cover the mortgage if they have to sell the home due to the borrower defaulting and the lender foreclosing.
The Bottom Line
Your loan-to-value ratio is an important number and one worth knowing. Lenders use LTV ratios to ensure that borrowers are not getting in over their heads by borrowing too much money compared to the home's value. A lower LTV ratio can be achieved through a larger down payment or, for existing homeowners, an increase in the home's market value.
