Mortgage Q&A: “What is the loan-to-value ratio?”
You’ve probably heard the phrase loan-to-value ratio get thrown around a lot lately, what with all the stories of negative equity and underwater homeowners. The same might be true if you’ve been shopping for a mortgage.
Regardless of what’s going on in the housing market, you should know this important term when applying for a mortgage to ensure you get the best deal as it can greatly affect pricing and loan eligibility.
How to Calculate the Loan-to-Value Ratio (LTV)
Put simply, the loan-to-value ratio, or “LTV ratio” as it’s more commonly known in the industry, is the mortgage loan amount (or existing balance for a refinance) divided by the purchase price or current appraised value of the property. When calculating it, you will wind up with a percentage. That percentage is your LTV.
It’s actually very easy to calculate (no algebra required) and takes just one step. Honest!
Let’s calculate a typical LTV ratio:
Property Value: $500,000
Loan Amount: $350,000
Loan-to-value Ratio (LTV): 70%
In the above example, we would divide $350,000 by $500,000 to come up with a loan-to-value ratio of 70%.
Using a calculator, simply enter in 350,000, then hit the divide symbol, then enter 500,000. You should see “0.7,” which translates to 70%.
This means the borrower has a loan for 70 percent of the property value, with the remaining 30 percent the home equity portion, or ownership in the property.
LTV ratios are extremely important when it comes to mortgage rate pricing because they represent how much skin you have in the game, which is a key risk factor.
A Lower LTV Ratio Means More Ownership, Better Rate
Essentially, the lower the loan-to-value ratio, the better, as it means you have more ownership (home equity) in the property. Someone with more ownership is less likely to fall behind on payments or foreclose, seeing that they have a greater equity stake, aka financial interest to keep paying each month.
Not only that, but banks and mortgage lenders also set up pricing adjustment tiers based on the LTV ratio. Those with lower LTV ratios will enjoy the lowest interest rates available, while those with high LTVs will be subject to higher costs and rates.
For example, if you’re being hit for having a less-than-stellar credit score, that adjustment will grow larger as the loan-to-value ratio increases (higher LTV ratio = greater risk).
So if your mortgage rate is bumped a quarter of a percent higher for a loan-to-value ratio of 80%, that same pricing hit may be increased to a half a percent if the LTV ratio is 90%.
This can certainly raise your interest rate in a hurry, so you’ll want to look at all possible scenarios with regard to down payment and loan amount to keep your LTV ratio as low as possible.
80% LTV Is a Very Important Threshold!
Most borrowers (who are able to) elect to put 20% down, as it allows them to avoid the need for mortgage insurance and the higher pricing adjustments often associated with LTVs above 80%.
But you don’t necessarily need to put 20% down to enjoy the benefits of a low-LTV mortgage.
Looking at the above example again, if you were to raise the first mortgage amount to $400,000 and add a second mortgage of $50,000, the combined loan-to-value ratio, or CLTV, would be 90%.
Simple math: $400,000 + $50,000 = $450,000 / $500,000 = 90% CLTV
You would have a first mortgage at 80% LTV, and a second mortgage for an additional 10% LTV, making the CLTV 90%.
Sometimes borrowers elect to break up home loans into a first and second mortgage, known as combo mortgages, to keep the loan-to-value ratio below key levels, thereby reducing the interest rate and/or avoiding private mortgage insurance.
Keep in mind that banks and lenders also have LTV and CLTV limits, meaning they won’t allow homeowners to borrow more than say 80, 90, or 100 percent of the property value (these limits have come down since the mortgage crisis got underway but are creeping back up again).
Max LTV by Loan Type
There are certain LTV limits based on loan type, with conventional offerings (non-government) typically being more restrictive than government loans.
At the moment, you can get an FHA loan as high as 96.5% LTV, which is just 3.5% down.
You can get a conventional loan as high as 97% LTV, which at 3% down is higher than it used to be. A year or two ago the max was 95%, but now Fannie Mae and Freddie Mac are competing directly with the FHA.
Finally, you can get either a VA loan or USDA loan at 100% LTV (no money down). These are the most flexible loan programs LTV-wise, but they are also only available to veterans or those living in rural areas, respectively. So not everyone will qualify.
And finally, those underwater or upside down borrowers you hear about; they owe more on their mortgage than the property is currently worth. This can happen due to negative amortization and/or home price depreciation.
A quick underwater loan-to-value ratio example:
Property Value: $400,000
Loan Amount: $500,000
Loan to Value Ratio (LTV): 125%
As you can see, the underwater borrower has a LTV ratio greater than 100% (negative equity), which is a major problem from a risk point of view.
The problem with borrowers in these situations is that they have little incentive to stick around, even with a modified mortgage payment, as they’re so far in the red that there’s little hope of recouping home value losses.
However, it just so happens that the Home Affordable Refinance Program allows loan-to-values up to 125 percent. And now there’s no LTV limit!
So there are options to refinance and get a lower interest rate, as long as your loan is owned by Fannie Mae or Freddie Mac.
Despite being far behind new homeowners entering the market in terms of building equity, many of these formerly underwater borrowers now have lots of equity thanks to years of home price appreciation and years of paying down their mortgages. That’s why you have to consider the long-game and never give up.
How to Lower Your LTV
If your LTV is higher than you’d like it to be, there are some options to lower it. Doing so may result in a more favorable mortgage rate or expanded loan program eligibility.
Borrowers can lower their LTV in two main ways.
If it’s a purchase, simply bring in more down payment money and the LTV will be lower.
If it’s a refinance, simply pay down the mortgage balance a bit more before you apply, whether on schedule or by making extra mortgage payments.
Another way existing homeowners can get their LTV down is if home values increase. You don’t have to do anything except sit back and watch your house value increase, thereby lowering your LTV. Of course, the opposite can happen too!
Read more: 10 ways to build home equity.