Loan-to-value ratios (LTVs) help a lender determine how much risk they’re taking on with a secured loan. It calculates the relationship between the loan amount and the asset securing the loan, like a house or car.
What Is the Loan-to-Value (LTV) Ratio?
The loan-to-value ratio (LTV) is used by financial institutions and other lenders to assess the loan’s risk. Loans with high LTV ratios are typically considered higher-risk loans. As a result, if the mortgage is approved, the loan will have a higher interest rate.
Furthermore, a loan with a high LTV ratio may require the borrower to purchase mortgage insurance to compensate for the lender’s risk. Such insurance is called private mortgage insurance (PMI).
Importance of the Loan-to-Value Ratio
Generally, a high LTV ratio indicates a high level of lending risk. The rationale behind this is that the purchased property (e.g., house) in the mortgage is used as collateral. Thus, the LTV ratio essentially compares the size of the loan requested to the size of the pledged collateral.
Due to the abovementioned reason, the assessment of the LTV ratio serves a crucial role in mortgage underwriting. For example, conventional mortgage lenders usually provide good loan terms if the LTV ratio is less than 80%.
What is a good loan to value ratio
An LTV of 80% or less is ideal when you’re taking out a conventional loan. Typically, conventional mortgages with an LTV ratio over 80% require PMI, which can add tens of thousands of dollars to your total mortgage payments.
How do you calculate loan to value
Understanding the Loan-to-Value (LTV) Ratio
Interested homebuyers can easily calculate the LTV ratio of a home. This is the formula:
To determine your LTV ratio, divide the loan amount by the value of the asset, and then multiply by 100 to get a percentage:
LTV = (Amount owed on the loan ÷ Appraised value of asset) × 100
In other words, the LTV is the proportion of the property’s appraised value that isn’t covered by your down payment. With 15% down, your LTV would be 85% if the rest of the purchase price was covered by the loan.
While lenders and federal housing regulators place the most importance on the LTV ratio when the loan is issued, you can calculate the LTV at any time during the loan’s repayment period by dividing the amount owed on the loan by the appraised value of the property.
As you repay the loan, the amount owed decreases, which tends to lower LTV. If the value of your property increases over time, that also reduces LTV. But if the property’s value drops (if housing prices fall significantly in the local market, for instance), that can push LTV higher.
How LTV is Used by Lenders
LTV is one of several factors that determine eligibility for a mortgage, home equity loan, or line of credit. It can, however, have a significant impact on the interest rate that a borrower can obtain.
When borrowers’ LTV ratios are at or below 80%, lenders usually offer them the lowest possible interest rates.1 A higher LTV ratio does not preclude borrowers from being approved for a mortgage, but the interest rate on the loan may rise as the LTV ratio increases.
For example, a borrower with an LTV ratio of 95% may be approved for a mortgage. However, their interest rate may be a full percentage point higher than the interest rate given to a borrower with an LTV ratio of 75%.
Disadvantages of Loan-to-Value (LTV)
A major disadvantage of LTV information is that it includes only the primary mortgage owed by a homeowner and excludes any other obligations the borrower may have, such as a second mortgage or home equity loan. As a result, the CLTV is a more comprehensive measure of a borrower’s ability to repay a home loan.
If you’re applying for an auto loan or a mortgage, it’s essential to understand how your LTV ratio affects your overall borrowing costs and how you can decrease your LTV. Doing this will save you money over the course of the loan.