What is the Loan to Value Ratio
The Loan-to-Value Ratio is one of the most important basics when it comes to applying for a mortgage.
If you are shopping for a new home or are already applying for a mortgage then you will have heard of the loan-to-value ratio before. The acronym LTV is used a lot in the news, as well, and cropped up frequently when people found themselves in negative equity when the housing market crashed over a decade ago.
No matter what the situation in the housing market, it is important that you understand LTV, and that when you apply for a home loan you get the best deal that you can. Having an LTV that is too high can mean that you have to pay a lot more for your mortgage and that your refinance options and loan eligibility become poorer.
The LTV ratio is easy to calculate:
- Just divide the loan amount you are applying for by the appraised value of the property.
- That gives you the ‘loan to value’.
- The hard part is determining the true value of your home.
- The LTV ratio is the amount of the mortgage loan, divided by the purchase price or the appraised value of the property (whichever is lower).
If you are refinancing a mortgage, then the LTV is the outstanding loan balance divided by the property’s appraised value.
Lower LTV figures are better when it comes to getting a good rate on your mortgage.
Let’s take a look at a few simple calculations
Let’s calculate a typical LTV ratio:
- Property value: $600,000
- Loan amount: $450,000
- Loan-to-value ratio (LTV): 75%
In the above example, we would divide $450,000 by $600,000 which gives us a result of 0.75, or 75%
You can do calculations like that in your head, or using a standard calculator. There is no need to use an online “LTV Calculator”. The arithmetic is not complicated and it’s a one-step process. It’s something that anyone can do, and it will arm you with some useful information for getting ready to apply for a mortgage.
Once you know your loan to value, that gives you an idea of the equity you hold in the property. In this case, your loan is for 75% of the property, so the remaining 25% of the property is the ownership that you hold.
It is important to know your proposed (or current) LTV so that you can show to the lenders that you actually have some money to put into the property. Lenders like to know how much of a risk they are taking when they allow someone to borrow from them.
Lower LVR ratios mean you own more of the property and are likely to get a better mortgage rate.
The more equity you have or the bigger the downpayment you can put in, the better.
Low LTV means less risk and less interest.
If someone has more ownership then they are less likely to end up falling behind on their payments and the mortgage company is less likely to need to foreclose on them because the homeowner has more to lose.
If they do end up struggling with payments, they could sell the property and not be faced with a massive loss.
Mortgages are tiered, with the tiers based on the LTV ratio. Someone who has a lower LTV ratio will be able to get lower interest rates, and those who have a higher LTV will have to pay a bigger mortgage or more closing costs.
Let’s consider a situation where you have a less than perfect credit score, and lenders want to charge you more interest. The adjustment you are faced with will grow even more if you have a higher loan to value ratio because that means even greater risk.
If you have a loan to value ratio of 80 percent and a poor credit score then that could mean you are faced with a .25 percent higher mortgage rate. If your loan to value ratio was 90 percent then the hit could be 0.5 percent. That might not sound like a lot, but over the term of the mortgage, it could see you paying an awful lot more. It makes sense to find ways to make a bigger down payment and to bring your mortgage as low as possible.
If you can, try to repair your credit score over a few years as well so that you have more loan options open to you, regardless of your equity and downpayment.
The 80% LTV Threshold Matters
It is important to keep your LTV below 80%
That will help you to secure a lower interest rate for your mortgage
It will also help you to avoid Private Mortgage Insurance
Most borrowers will elect to put down a deposit of at least 20%l so that they can avoid mortgage insurance and pricing adjustments
You don’t always need to put down 20% to get the benefits of having a lower LTV, though.
Looking at our first example once more, let’s raise the initial mortgage to $480,000 and add an additional mortgage of $60,000. This gives a combined loan-to-value ratio of 90% since the total amount borrowed is $540,000 on a $600,000 property.
The first mortgage is for 80%, and the second mortgage is for 10%.
Breaking up home loans into ‘combo mortgages’ allows you to keep the loan to value below the threshold, reducing the interest rate and also avoiding the need for private mortgage insurance. Many borrowers opt to do this.
Banks and mortgage companies do have limits on the LTV and CLTV that they allow, so you are not going to be able to borrow more than the property is worth. Many lenders set their thresholds at 80, 90 and 100 percent depending on the value of the property and the credit history of the borrower. These limits were introduced when the credit crunch hit, and they are gradually being relaxed, but it still makes sense to be cautious with borrowing.
If you are looking for a mortgage at the moment, then you are likely to have heard a lot about loan to value ratios. Hopefully, those figures will have cleared things up for you, and you will have some idea of what you should be aiming for. If you want to minimize the interest that you pay and improve your prospects of getting accepted by a good lender for the property of your dreams then you would do well to try to reduce your loan to value as much as you possibly can.
Out of all of the elements of working out mortgage eligibility and how much interest you might pay, figuring out the loan to value ratio is perhaps the easiest. Just divide the amount of the loan by the appraised value to get the LTV.
The hard part is often working out the value of the property.
The loan to value ratio, or LTV, is the value of the being applied for divided by the worth of the property (defined as the lower out of the appraised value and the purchase price).
In the case of an existing mortgage, this is the outstanding loan balance, divided by the most recent appraised value.
The lower the number that you get when you calculate the LTV, the better.
If you are lucky enough to be dealing in fairly round numbers, you should be able to calculate the LTV in your head, for example:
- Property value: $1,000,000
- Loan amount: $700,000
- Loan-to-value ratio (LTV): 70%
All you have to do is divide the loan amount ($700,000) by the value of the property ($1,000,000). This gives us 0.7, or 70%.
You can do this on a calculator, or in your head. There is no need to use a specialist LTV calculator, although if you’re already on a mortgage website then you might want to try it just to use their other tools as well.
The result, 70% is good, because it means that the hypothetical borrower has 30% ownership of the property. This means that lenders will view them as fairly low risk and that they might get a good rate for their mortgage.
- Lower LTV ratios mean that you own more of the property
- Lenders see this as a good thing and offer better rates
- A low LTV means more equity in the property or a bigger down payment
- More equity means less risk for the lender
- There are ‘breakpoints’ where if you get the LTV below that level you will be offered more favorable mortgage rates from the mainstream lenders
The lenders know that if someone has more ownership they are less likely to fall behind on their loan repayments and that in the event that they do fall on hard times they are more likely to be able to just sell the property without ending up facing a loss. This means that it is safer to lend to those people and that they will get better prices. In many cases, those with very low LTV ratios will not just see lower interest rates, but also lower closing costs. Keeping the LTV below 80% is valuable too because it helps to avoid private mortgage insurance.
Someone who has a poor credit score should look to avoid a high LTV because they will already be getting charged more for their mortgage. By reducing their overall risk they can reduce the negative impact that their poor credit score is having on them, although improving the score as well will go a long way.
Someone who has a poor credit rating and pays 0.25% more than average for an LTV or 80% would likely end up paying 0.5% more for an LTV that is above 90%. It makes sense, then, for those who have poor credit histories to look for ways to reduce their LTV to below the 80% threshold. The lower the loan to value ratio is, the better, for any borrower but especially for those who have a poor credit rating.
In the long term, building a good credit history is the best option for anyone, whatever their situation. Those who are planning to apply for a mortgage should definitely investigate their credit history.
The Crucial 80% LTV Threshold
- You should always aim to have an LTV of below 80%
- This will save you a lot of money
- Lower LTV ratios mean lower interest rates
- An LTV below 80% will allow you to avoid private mortgage insurance (PMI) too
- The traditional way of avoiding higher LTVs is to put down a deposit of 20% when you buy a home so that you can reduce the total amount you pay over the term of the mortgage
You don’t have to do that though, there are other ways to save money on your mortgage and reduce the LTV.
One option is to take out a first and a second mortgage. The total (or ‘combined loan to value ratio’) of the two mortgages may be above 80%, but each mortgage will have a lower loan to value.
For example, you could borrow $800,000 on one mortgage and $100,000 on another, for a combined loan to value of 90% on a $1,000,000 property. The bigger of the two mortgages, however, would still be just 80%. The CLTV would be 90% because the other mortgage has an LTV of 10%.
Combo mortgages can help to keep the LTV on each mortgage below key thresholds, and this will help you to avoid higher interest rates and the misuse of private mortgage insurance. There are limits on the size of the total loan that you can take out and you will not usually be able to borrow more than the total value of the property. Many lenders prefer people to not borrow more than 90 percent of the property value, depending on your credit history.
There are different limits depending on the type of home that you want to buy.
- FHA loans can often be as much as 96.5%
- Conforming loans may reach 87%
- VA and USDA loans are often allowed to be zero deposit/100% LTV
If you are buying an investment property, jumbo or cash-out refi then you are likely to see more restrictions on the total amount that you can borrow. Non-government loans are likely to be more restrictive than a government one as well. Refinances can sometimes be less flexible than loans to purchase a house in the first place.
Loan amounts are increasing. It wasn’t all that long ago that the limit for an FHA loan was 95%, but now Fannie Mae and Freddie Mac are in competition against the FHA which is driving loan amounts up.
Veterans and those who live in rural areas may be able to borrow more than those who are in bigger cities. It is a good idea to shop around, wherever you are buying a property because there are a number of options to buy properties from private lenders that may be willing to offer more flexible financing. There is no need to head straight to the lenders that are advertising on TV. A little legwork could save you a lot of money.
If you have a higher LTV than you would prefer, the good news is that there are a number of ways that you could potentially reduce it.
Borrowers Have Options to Lower Their LTV
For a home purchase loan, use a larger downpayment.
Ask for gift funds as a way of making your downpayment greater.
Break your mortgage up into a combo loan.
Make additional payments or put in a lump sum payment and refinance so that the LTV is lower when you apply.
Wait for amortization and appreciation of the home to reduce your LTV over time.
If you’re purchasing a new property, then the main option is to save and have a bigger downpayment. Yes, that’s not always easy, but it is often possible.
Ask if someone is willing to act as a co-borrower for you or to gift you the money.
Alternatively, look into ways of breaking up the financing into separate loans, and having a first and second mortgage.
With refinancing, you have the option of paying the balance down more aggressively before you apply. Make extra mortgage payments, or wait a bit longer before refinancing.
This could help you if you are close to the LTV threshold, or you need to get below a conforming loan limit.
It’s important to pay close attention to the LTV, because if it is above 80% then you may be paying more than you need to. There are other thresholds, too, where if you can reduce the LTV you may pay less interest.
If you aren’t under urgent need to refinance, then why not take the zero effort approach to reduce your LTV. Just sit back and watch as your house value increases over time. This will lower the LTV in the process. Of course, that isn’t guaranteed to happen. Home values can fall as well as rise.
In general, real estate prices rise over the long term, so your best bet is to be willing to ride out the changes, and to refinance at a time when it is financially suitable for you.
With people who are looking for a cash-out refinance, a jumbo loan, or to acquire some investment property, there are far more restrictions. The Loan to Value is likely to be limited to 70 or 80% at most.
Be aware that if you borrow a lot of money you are taking a big risk. There are borrowers who are now in negative equity because they owe more on their current mortgage than the value of the property today. This can happen for many reasons, and since the housing market is cyclical, you can never be sure that your ‘expensive’ house today will still be in demand in ten year’s time.
Having negative equity (an LTV ratio that is over 100%) is not a problem if you can meet the repayments on your mortgage and you are not planning on moving. It is a problem if you need to move home or if you need to refinance your mortgage. It’s also a problem if you are on a mortgage that is not fixed rate, and the lender charges you more because your LTV is so high.
The Home Affordable Refinance Program has helped a lot of ‘underwater’ homeowners to get back into the black by refinancing on a lower rate without a limit to their LTV. You will need to have a loan that is under Fannie Mae or Freddie Mac if you want to take advantage of that refinance option. There are similar options such as FHA streamline refinance for FHA loans or the VA IRRRL for VA mortgages.
Underwater borrowers can recover. It may take them some time to get back to the same financial standing as someone who bought when the property market was low, but it is possible for them to build equity if they are patient and think long term.
Home buying should not be a hasty decision. It is something that you should work on steadily.
Remember the following:
- Lower LTV ratios mean bigger savings
- You will usually get lower interest rates with bigger deposits
- Long term, you will pay less to repay the mortgage
- Put more of your money towards paying off the principle by having a low LTV
- Keep your LTV under 80% to avoid PMI
- You will have access to more lenders if you have a lower LTV
- Even people who have a poor credit rating can save money by using a bigger deposit
- You are more likely to get approved for a mortgage if the lender sees you as being lower risk.