Mortgage Q&A: “What is the loan-to-value ratio?”
Put simply, the loan-to-value ratio, or “LTV ratio” as it’s more commonly known, is the mortgage loan amount (or balance) divided by the purchase price or current appraised value of the property. When calculating it, you will wind up with a percentage.
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, the loan-to-value ratio is 70%, meaning the borrower has a loan for 70 percent of the property value, with the 30 percent remainder 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.
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 for a loan-to-value ratio of 80%, that 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).
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, as long as your loan is owned by Fannie Mae or Freddie Mac. It just means they are way behind new homeowners entering the market in terms of building equity.
For the record, borrowers can lower their LTV in two ways. One way is simply by paying down the mortgage balance, whether on schedule or by making extra payments. At the same time, if home values increase, the LTV is lowered that way as well.
Read more: 10 ways to build home equity.