Monday 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 borrowers.
Put simply, the loan-to-value ratio, or “LTV ratio,” is the loan amount divided by the purchase price or appraised value of the property.
You will wind up with a percentage.
Let’s look at an example:
Property Value: $500,000
Loan Amount: $350,000
Loan to Value Ratio (LTV): 70%
In the above example, the loan-to-value ratio is 70 percent, meaning the borrower has a loan for 70 percent of the property value, and 30 percent remaining home equity, or ownership, in the property.
Lower Loan-to-Value Ratio Means More Ownership
Essentially, the lower the loan-to-value ratio, the better, as it means you have more ownership (home equity) in the property.
Not only that, but banks and mortgage lenders also set up pricing adjustment tiers based on loan-to-value ratio.
In other words, if you’re being hit for having a less-than-stellar credit score, that hit 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 for a loan-to-value ratio of 80 percent, that hit may be increased to a half a percent if the loan-to-value ratio is 90 percent.
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.
80% LTV is an Important Threshold
Most borrowers, who are able to, elect to put 20% down, as it allows them to avoid mortgage insurance and the higher pricing adjustments often associated with LTVs above 80%.
But you don’t necessarily need to put 20% down to get the benefits of a low-LTV mortgage.
Looking at the above example again, if you were to add a second mortgage of say $50,000, the combined loan-to-value ratio, or CLTV, would be 80 percent.
Simple math: $350,000 + $50,000 = $400,000 / $500,000 = 80% CLTV
You would have a first mortgage at 70% LTV, and a second mortgage for another 10% LTV, making the CLTV 80%.
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 in check, thereby reducing the interest rate and/or avoiding private mortgage insurance.
Keep in mind that banks and lenders also have LTV limits, meaning they won’t allow homeowners to borrow more than say 80, 90, or 100 percent of the property value (these LTV limits have come down since the mortgage crisis got underway).
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%
The problem with these borrowers is that they have little incentive to stick around, even with a modified mortgage payment, as they’re so far in the red there’s little hope of recouping losses.
And it just so happens that the Home Affordable Refinance Program allows loan-to-values up to 125 percent.
Of course, as property values increase, the LTV ratio will eventually fall. So there is some hope for borrowers in this situation, assuming they can stomach it.
It just means they are way behind new homeowners entering the market in terms of building equity.
Read more: 10 ways to build home equity.
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