Loan-to-Value ratio, or LTV ratio, is a risk assessment tool lenders use before approving a mortgage. In general, the higher the LTV, the more risk associated with the loan and, if the mortgage is approved, it will usually cost the borrower more.
Your loan-to-value ratio compares the value of your loan to the value of your home. To determine the LTV, your lender will divide your loan amount by either the purchase price or the appraised value of the home, whichever is lower.
For example, a mortgage of $300,000 on a home appraised at $400,000 has a LTV of 75%.
When Loan-to-Value is Important
LTV plays an important role in several situations. When you purchase a home, the value of the LTV equation is determined by the appraised value or purchase price of the home. The purpose of this is to prevent the lender from giving a loan for more than the home is worth, or lending more than the borrower was willing to pay.
The down payment you provide also affects the LTV and the lender's decision to approve the loan. If the down payment is less than 20% and results in a LTV of more than 80%, the lender will typically require mortgage insurance. Mortgage insurance is an additional premium included in the monthly mortgage payment and ranges from 0.22% to nearly 1% of the loan each year.
If you are already paying private mortgage insurance (PMI), it can be removed once you reach 80% LTV. This may happen if home prices rise dramatically, you pay the loan down early or you continue to make regular monthly payments for several years until your loan is paid off enough.
The loan-to-value ratio is also considered if you plan to refinance your mortgage. When refinancing, the appraised value of the home is used in the equation, and this appraised value is based on sales of comparable homes in the last three months.
When the LTV is higher than 70%, there is often a 0.125% increase in the mortgage rate for every 5% increase in LTV. This means an 85% cash out mortgage will be 0.375% more than a 70% cash out mortgage. The concept behind this is the homeowner will have less of a vested interest in the property the more equity that is removed.
When you get a conventional loan, you will typically be limited to 80% LTV if you want to avoid private mortgage insurance. There are loan options that allow for an LTV greater than 80%, however. FHA loans allow for a purchase up to 86.5% LTV while USDA loans and VA loans guarantee purchase loans up to 100% LTV.
The Lower LTV, The Better
The lower the ratio of the loan to the appraised value of the home, the more favorably a lender will view the risk of the mortgage and the greater the chance that your mortgage will be approved. High LTV ratios are typically reserved for consumers with the highest credit scores and a satisfactory mortgage history. 100% LTV is reserved for the most credit worthy borrowers.
The best way to lower the loan-to-value ratio when buying a home is putting down a larger down payment, which means you will automatically have equity in the home when you buy, as well as more vested interest in making payments. Getting the LTV as low as possible will also secure you the best interest rate on your mortgage.
Like any other lending risk assessment tool, the LTV ratio is not used solely in assessing a mortgage application. Lenders will also consider your debt-to-income ratio, your down payment and your credit. Lenders will always consider the risk of default when making a decision to give a mortgage, and the chance of the lender taking a loss increases as the amount of equity in the home decreases.