What Is The Loan-To-Value Ratio?
The loan-to-value (LTV) ratio is an important risk assessment metric lenders use to determine the level of risk an applicant presents.
Those with a high LTV may not be approved for a mortgage or may be required to purchase homeowners' insurance in order to secure the mortgage.
LTV is also important for those who are looking to secure equity-based loans, such as a home equity line of credit (HELOC).
Ultimately, the ratio is used to determine what amount an individual would need to provide as a down payment when taking out a mortgage.
Typically speaking, lenders like to see a ratio of 80% or less, and the lower the ratio, the more affordable the interest rate.
The LTV Formula
Calculating this valuable ratio is simple and can be done using the following formula.
LTV Ratio = MA/APV
MA = Mortgage Amount
The loan-to-value ratio is calculated by dividing the total value of the mortgage, or the amount borrowed, by the current appraisal value of the home.
For example, let's say an applicant is applying for a HELOC and their current mortgage amount is $250,000 and the current appraisal value of the home is $320,000. Using the provided formula above, we arrive at the following:
|LTV Ratio = 250,000/320,000 |
LTV Ratio = .78%
The calculation is often used to determine what amount a mortgage applicant would need to provide as a downpayment.
Typically, down payments of 20% or more are recommended given anything less will require the borrower to purchase expensive Private Mortgage Insurance (PMI).
Why LTV Is So Important To Lenders When Making Their Assessment
Whether it be for purchasing a new home, refinancing a current mortgage, or borrowing against equity, the loan-to-value ratio is a very important part of the underwriting process.
Lenders use this metric to assess the risk profile of an applicant and determine the appropriate interest rate.
Mortgages that are the total of or close to the current appraisal value of a home are high ratio loans.
Should the borrower default on their mortgage early on, there is little equity in the property and it may be difficult for the lender to sell.
This is the main reason why mortgages that carry a loan-to-value ratio of over 80% require the purchase of private mortgage insurance, given it protects the lender from any losses that may occur as a result of borrower default.
Additionally, this is also the reason why high ratio loans come with higher interest rates; the riskier the loan, the higher the interest charged.
The Relationship Between LTV And Interest Rates
When applying for a mortgage, home equity line of credit, or mortgage refinancing, lenders look at a variety of factors when determining what interest rate to charge a borrower.
The loan-to-value ratio is among these factors and has a large role to play in what interest rate and terms an applicant will receive.
Generally speaking, it is recommended that borrowers exhibit a ratio of 80% or less.
That being said, a higher loan-to-value ratio does not mean that an applicant will be denied, it just means that they will likely receive a higher interest rate than they otherwise would.
For example, an applicant with an LTV ratio of 90% may still be approved, but will likely receive an interest rate a full percentage point higher than if they had a ratio closer to 75%.
On top of this, obtaining financing with a loan-to-value ratio of over 80% will require the borrower to purchase private mortgage insurance, which could add a further 0.5% - 1.0% interest. Together, a high ratio and PMI can increase a borrower's interest rate by 1.5% - 2.0%, which on a $500,000 mortgage would mean hundreds of dollars more in monthly payments.
What Is Considered A Good LTV?
The lower the loan-to-value ratio, the less risk a borrower presents to a lender, resulting in lower interest rates.
Most financial planners recommend home buyers have a ratio of 80% or less.
This improves the chances of loan approval and severely decreases the likelihood that the borrower will need to purchase private mortgage insurance.
It is worth noting that when applying for a cash-out refinancing, the acceptable ratio increases to 90%, and some government leaders, such as the VA and USDA, will approve loans that carry a ratio of 100%.
The loan-to-value ratio is a very important aspect of consideration for all homebuyers. It plays a large role in determining what interest rate borrowers receive. Moreover, having too high a ratio may require the borrower to purchase expensive private mortgage insurance.
To avoid this, it is recommended that applicants maintain an LTV ratio of 80% or less.