Loan-to-Value Ratio: What is it and Why is it Important?
During the mortgage approval process, one of the main things that home loan lenders will look at to either approve or deny you for a mortgage is your loan-to-value (LTV) ratio.
And if you are approved for a mortgage, your LTV ratio, in addition to things like your credit score, will have a further impact in determining what type of mortgage terms you receive, specifically your interest rate.
With the amount of weight that your LTV ratio carries for the mortgage and home buying process, you really want to make sure you have fully grasped the concept, in addition to knowing how to calculate your loan-to-value ratio.
What is Loan-to-Value Ratio?
LTV ratio is what you owe on your mortgage balance divided by the current value of your home. For lenders, your specific LTV ratio gives them a better idea as to the chances of you defaulting on your home loan.
Why is Loan-Value-Ratio Important?
Your LTV ratio is really one of the most important things to consider when you are applying for a mortgage in the hopes of becoming a homeowner.
Remember, mortgage lenders are usually putting hundreds of thousands of dollars at risk when providing you with a home loan. These lenders want to be absolutely sure you will be able to meet monthly mortgage payments with interest until the debt is fully paid off. If not and you enter default and eventually get foreclosed on, the lender can sell your home but may still not fully recoup their initial investment.
This is why your LTV ratio will come into play.
In addition to things like your credit score and the size of your down payment, your LTV ratio will seriously impact your chances of approval, in addition to the interest rate you receive on the home loan.
And, the higher your LTV ratio, the riskier you look in the eyes of a mortgage lender. Ideally, a home loan lender wants to see a LTV ratio of 80% or lower, which usually can be had with a 20% down payment that directly reduces your LTV ratio.
If you can’t do this and your LTV ratio creeps towards 90% or higher, a few things can happen. For starters, you may simply get denied for a mortgage.
But, if you get approved for a mortgage despite a high LTV ratio, you will almost surely get an unfavorably high interest rate and mortgage terms, in addition to having to pay for private mortgage insurance (PMI).
On the flip side, a low LTV ratio will be appealing to home loan lenders as it is a good indicator that you will be financially stable while still meeting your monthly mortgage payments.
Further, if the value of the home is high and your mortgage balance is relatively low, the risks of default are somewhat mitigated since the lender can feel comfortable in recouping its losses and possibly even turning a sizeable profit if you do indeed fall victim to foreclosure.
For these reasons, a low LTV ratio will likely lead to you getting a very favorable interest rate from a mortgage lender.
Calculating Your Loan-to-Value Ratio
How do you calculate your LTV ratio? The calculation is actually quite simple and is expressed as a percentage.
To calculate your LTV ratio, simply divide the size of your mortgage loan by the current value of the home.
For example, let’s say that you are looking to purchase a home that is currently valued at $500,000, and you saved enough to make a $100,000 down payment on this home.
This means that your mortgage loan would be $400,000 after deducting the down payment. So to get the LTV ratio, you would divide $400,000 by the current home value of $500,000 and end up with an LTV ratio of 80%.
Your loan-to-value ratio is 80% of the property’ value; this would likely lead to approval and favorable mortgage terms.
What is a Good Loan-to-Value Ratio?
Generally, an LTV ratio of 80% or lower should be the target for any prospective homebuyer, especially if you are looking at a conventional mortgage.
For standard home loans, a LTV ratio above 80% will not only lead to a high interest rate, but also likely make PMI necessary.
However, if you are looking into an FHA home loan that allows you to make a down payment as low as 3.5%, an LTV ratio of 96.5% is usually acceptable.
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