Why Do Loan-to-Value Ratios Matter?

Why Do Loan-to-Value Ratios Matter?

Why Do Loan-to-Value Ratios Matter?

Your loan-to-value (LTV) ratio is a comparison of the amount of money you’re borrowing and the value of the asset you’re buying. It can be especially important when buying a home because mortgage lenders often use LTV ratios to help determine who to approve, how much money to lend, and how much interest to charge. 

Learn how to calculate your ratios and lower your LTV, which can make it easier and less expensive to borrow money. 

The Loan-to-Value Ratio Formula and Calculations

Loan-to-value calculations are simple to do once you know which numbers to use. For the basic LTV formula, you’ll divide the amount of money you’re borrowing by the asset’s appraised value. 

  • Loan amount / appraised value = LTV

For example, if you take out a $200,000 mortgage to buy a home that’s appraised at $250,000, the calculation will be:

  • 200,000 / 250,000 = .80

LTV ratios are generally represented as a percentage, so your LTV ratio is 80%. 

The one potentially tricky part is that lenders use the appraised value of the asset, which could be different than the selling price. 

Continuing with the example above, perhaps the current owner is desperate to sell the home and agrees to take $225,000. If you borrow $200,000, you’re paying less out of pocket, but your LTV is the same because the loan amount and appraised value don’t change. 

However, after your purchase, the LTV ratio can change as you pay down the loan and the home’s appraised value rises or falls. The current LTV can be important because it impacts your ability to refinance the mortgage or take out additional loans against the home.

Combined LTV Ratios

If you want to use an asset as collateral for more than one loan, the lender may calculate a combined loan-to-value (CLTV) ratio when evaluating your application. This often happens when you’re taking out a second mortgage, such as a home equity loan (HEL) or a home equity line of credit (HELOC). 

The basic formula is the same, but you’ll add up all the loan amounts and then divide the sum by the appraised value. 

  • Combined loan amounts / appraised value = CLTV

If your home is currently worth $300,000 and you still owe $200,000 on your mortgage, your current LTV is: 200,000 / 300,000 = .67 or 67%

Perhaps you want to take out a HEL for $50,000 to repair your roof and upgrade several rooms. Your CLTV will be: (200,000 + 50,000) / 300,000 = .83 or 83%

What is a Good Loan-to-Value Ratio?

In general, a lower LTV is better and will make getting approved for a loan easier. However, what’s considered a good LTV will depend on the lender and type of loan. 

  • Conventional mortgage lenders require a minimum LTV of either 97% or 95%. But a good LTV on a conventional mortgage is 80% or lower. If your LTV is above 80%, you’ll likely have to buy private mortgage insurance (PMI). Although you have to pay for the PMI, it protects the lender from homeowners who default. 
  • For FHA loans, you may be able to get approved with an LTV of 96.5% if your credit score is 580 or higher. Or, 90% if your credit score is lower than 580. You’ll also have to pay for mortgage insurance with an FHA loan.
  • VA and USDA loans allow 100% LTV, meaning you don’t need to put any money down, and neither type of loan requires mortgage insurance. However, you’ll need to meet the requirements and may have to pay other upfront or ongoing fees. 

How to Lower Your Loan-to-Value Ratios

There are only two moving parts in the LTV ratio formula, the amount of the loan and the value of the asset. When you initially taking out the loan, you can lower your LTV by:

  • Making a larger down payment.
  • Using the same down payment and purchasing a less expensive home.

Afterward, your LTV will decrease as you repay your loan. Keeping track of your LTV can be especially important if you bought a home loan with less than 20% down (meaning an LTV of over 80%) and are paying for PMI. 

Once your LTV is 80% or lower, you can request to remove the PMI from a conventional mortgage. With an FHA loan, you may have to refinance your mortgage (again, with an LTV of 80% or lower) to stop making mortgage insurance payments. 

Lenders Consider More Than Your Loan-to-Value Ratios

While your LTV and CLTV can be important factors in a lender’s decision, the ratios are only one piece of the puzzle. Lenders will also consider other information to determine if you qualify for a loan and the amount, rates, and terms you receive. 

Your Credit

Your credit history and credit scores can be an indicator of how likely you are to miss a payment in the future. Lenders may have minimum credit score requirements, and your down payment, loan amount, and interest rate can depend on your scores. Even if you have a low LTV, you might not get approved for a loan if you have poor credit.

Your Debt-to-Income Ratio

Another important ratio is your debt-to-income (DTI) ratio. The ratio is a comparison of your monthly income to your monthly financial obligations, which may include loan payments, rent, alimony, and types of debts. 

A lower DTI is best as it indicates a smaller portion of your income goes toward these payments, and you’ll have more money left over for the lender. Generally, you’ll need a DTI below 36% to 43% (depending on the type of loan) to get a mortgage. 

Your Employment History

Lenders want to know that borrowers will have the means to repay the loan, and you may need to share your recent paychecks, W-2s, and tax returns to verify our income. Ideally, you’ve had a steady job for at least two years, or have several years of steady self-employment income. However, you can get a mortgage if you’ve recently changed jobs, especially if you stayed in the same industry and increased your income. 

Final Word: Loan-to-Value Ratios

When you’re looking to buy a home, your LTV ratio and down payment are two sides of the same coin. The more you can put down, the lower your LTV. You can use these calculations to figure out how expensive a home you can afford to buy, as you’ll need at least 3% down (a 97% LTV) for most types of mortgages. 

However, if you can afford a 20% down payment, you can avoid the extra payments for mortgage insurance. Lenders may also offer you a lower interest rate because they’re taking on less risk, and your monthly payments will be lower if you borrow less money.

This article was originally written on January 21, 2020 and updated on February 2, 2021.

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