The loan-to-value (LTV) ratio is a financial term that lenders use to express the ratio of a loan to the value of an asset being purchased. It is calculated by dividing the loan amount by the value of the investment.
For example, if you are taking out a mortgage to buy a house, the loan amount is $500,000, and the home’s value is $800,000, the LTV ratio would be 62.5%.
How to Calculate the Loan-To-Value (LTV) Ratio
To calculate the LTV ratio, you must divide the loan amount by the asset’s value. For example, if you are taking out a mortgage to buy a house and the loan amount is $500,000, and the value of the home is $800,000, the LTV ratio would be calculated as follows:
LTV ratio = loan amount/asset value, for example, $500,000/$800,000. LTV ratio = 62.5%
How Lenders Use Loan-to-Value (LTV) Ratios to Make Decisions
Lenders use the LTV ratio to determine the risk of lending money to a borrower.
A high LTV ratio means the borrower has a higher risk of defaulting on the loan because they borrowed a more significant amount relative to the asset’s value.
However, A low LTV ratio indicates that the borrower has a lower risk of default because they borrow a smaller amount relative to the asset’s value.
For instance, if a lender’s policy is to only lend money to borrowers with an LTV ratio of 80% or lower and a borrower is asking for a loan of $500,000 to purchase a home with a value of $600,000, the lender might not be willing to do so because the LTV ratio is 83%.
On the other hand, if the borrower is seeking $400,000 to buy a house valued at $600,000, the lender may be willing to lend the money because the LTV ratio is only 66%.
How Your Credit Score Impacts Your LTV Ratio
LTV ratio and credit score are related. If your credit score is higher, your LTV ratio might be lower, and vice versa. This is because lenders use credit scores to determine how risky it is to lend money to a borrower.
A high credit score indicates that the borrower has a good credit history and is more likely to repay the loan, which may result in a lower LTV ratio and interest rate.
On the other hand, a low credit score indicates a higher risk of default, which may result in a higher LTV ratio and a higher interest rate.
The LTV ratio is calculated based on the loan amount and the value of the asset being purchased, while credit scores are calculated based on a borrower’s credit history.
The LTV ratio and credit score are two separate but related factors that lenders consider when making lending decisions.
Here is an example of how the LTV ratio can affect a mortgage:
- Borrower A has a credit score of 700 and is looking for a $400,000 mortgage to purchase a $600,000 house. The LTV ratio is 66%.
- Borrower B has a credit score of 700 and is seeking a mortgage for $500,000 to buy a house with a value of $600,000. The LTV ratio is 83%.
The lender may offer Borrower A a mortgage with an interest rate of 3.5%. However, he may not be willing to lend the money to Borrower B because the LTV ratio is too high, or he may only offer a mortgage with a higher interest rate of 4.5%.
Different Types of Loans and their Associated Loan-to-Value Ratios
There are several types of loans that have different LTV ratios, including:
- Conventional mortgages: These are not insured or guaranteed by the government. The LTV ratio for a traditional mortgage is typically 80% or lower, but some lenders may allow higher ratios for borrowers with good credit.
- FHA loans: These are insured by the Federal Housing Administration (FHA). The LTV ratio for an FHA loan can be as high as 96.5% for a single-family home, but the borrower may have to pay mortgage insurance premiums to protect the lender in case of default.
- VA loans: These are guaranteed by the Department of Veterans Affairs (VA) for military service members and veterans. The LTV ratio for a VA loan can be as high as 100% for a single-family home, and the borrower does not have to pay mortgage insurance premiums.
- Jumbo loans exceed the conforming loan limit, which is currently $548,250 for a single-family home in most parts of the country. The LTV ratio for a jumbo loan is typically lower than for other loans, and the borrower may have to pay a higher interest rate.
LTV vs. Combined LTV (CLTV)
The LTV ratio is calculated based on the loan amount and the value of the asset being purchased. On the other hand, the combined loan-to-value (CLTV) ratio is calculated based on the total amount of all loans secured by a property and the property’s value.
For example, if a borrower has a first mortgage of $400,000 and a second mortgage of $100,000 on a property with a value of $700,000, the LTV ratio for the first mortgage is 57%, and the LTV ratio for the second mortgage is 14%. The CLTV ratio for both mortgages combined is 71%.
Impact of a High or Low LTV Ratio on Interest Rates and Down Payment Requirements
A high LTV ratio can result in a higher interest rate because the lender is taking on a higher risk of default. On the other hand, a low LTV ratio can result in a lower interest rate because the risk of default is lower.
Moreover, a high LTV ratio may require a higher down payment because the borrower borrows more than the asset’s value. A low LTV ratio, on the other hand, may require a more down payment because the borrower is borrowing a smaller amount relative to the asset’s value.
Benefits and Drawbacks of Having a High or Low LTV
There are both benefits and drawbacks to having a high or low LTV ratio.
Benefits of a high LTV ratio:
- A high LTV ratio may allow borrowers to buy a more expensive property because they borrow a significant amount relative to the asset’s value.
- A high LTV ratio may allow a borrower to have a smaller down payment, which can be helpful for those who have limited savings or cannot come up with a sizeable down payment.
Drawbacks of a high LTV ratio:
- A high LTV ratio can result in a higher interest rate because the lender is taking on a higher risk of default.
- A high LTV ratio may require the borrower to pay mortgage insurance premiums to protect the lender in case of default.
Benefits of a low LTV ratio:
- A low LTV ratio can result in a lower interest rate because the risk of default is lower.
- A low LTV ratio may allow the borrower to avoid paying mortgage insurance premiums.
Drawbacks of a low LTV ratio:
- A low LTV ratio may require a larger down payment because the borrower borrows a smaller amount relative to the asset’s value.
- A low LTV ratio may limit the borrower’s ability to buy a more expensive property because they borrow a smaller amount relative to the asset’s value.
The Impact of the Coronavirus (Covid-19) Pandemic on Loan-to-Value Ratios
The coronavirus pandemic has impacted the housing market and loan-to-value ratios. According to a report by the National Association of Realtors, home prices increased by 9.7% in 2020 due to low inventory and high demand. This increase in home prices has resulted in higher LTV ratios for some borrowers.
For example, if a borrower took out a mortgage for $400,000 in 2019 to buy a house valued at $500,000, the LTV ratio would be 80%. If the value of the home increases to $600,000 in 2020, the LTV ratio will increase to 66%.
Real Estate Appraisals and Loan-to-Value Ratios
Real estate appraisals are used to determine the value of a property to obtain a mortgage. The lender uses the appraisal to calculate the LTV ratio and determine the risk of lending money to the borrower.
If the appraisal value is lower than the property’s purchase price, the LTV ratio will be lower, which may result in a lower interest rate and/or a lower down payment requirement.
Common Mistakes to Avoid When Calculating an LTV Ratio
- Failing to include all loans secured by the property: If you have multiple loans secured by the property, it is essential to include them when calculating the LTV ratio.
- Using an outdated or incorrect value for the property: It is essential to use the most current and accurate value when calculating the LTV ratio.
- Not considering closing costs: Closing costs, such as lender fees and property taxes, should be included in the loan amount when calculating the LTV ratio.
Tips to Reduce Your Home Loan’s Loan-to-Value Ratio
- Make a larger down payment: A larger down payment will reduce the loan amount and, in turn, the LTV ratio.
- Pay off existing loans secured by the property: Paying off existing loans will reduce the total amount of loans secured by the property and, in turn, the LTV ratio.
- Improve the credit score: A higher credit score can result in a lower interest rate and, in turn, a lower LTV ratio.
Factors to Consider When Selecting a Mortgage Lender
- Interest rate: A lower interest rate can result in a lower LTV ratio.
- Down payment requirements: A lender that requires a smaller down payment may result in a higher LTV ratio.
- LTV ratio limits: Some lenders have limits on the LTV ratio they are willing to lend to borrowers. Finding a lender willing to lend to you at the LTV ratio you are comfortable with is essential.
Conclusion
The loan-to-value (LTV) ratio measures how much you borrow compared to the value of the asset you’re buying, like a house. It helps lenders decide whether to lend to you and at what interest rate.
A high LTV means you’re borrowing more and may have to pay a higher rate or a more significant down payment.
A low LTV may get you a lower rate or down payment. It’s essential to consider the LTV when choosing a lender and to avoid common mistakes when calculating it.
You can lower your LTV by making a larger down payment, paying off loans on the asset you’re buying, or improving your credit score. Consider the interest rate, down payment requirements, and LTV limits when picking a lender.
