What is a Loan-to-Value Ratio?

Credit: thebalance.com

loan-to-value (LTV) ratio compares the amount of a loan you’re hoping to borrow against the appraised value of the property you want to buy. A higher LTV ratio suggests more risk because there’s a higher chance of default.

Definition and Example of Loan-to-Value Ratio 

A loan-to-value ratio tells you how much of a property you truly own compared to how much you owe on the loan you took out to purchase it. Lenders use LTVs to determine how risky a loan is and whether they’ll approve or deny it. It can also determine whether mortgage insurance will be required.

  • Acronym: LTV ratio

For example, if you buy a home that appraises for $200,000 and make a down payment of $20,000, you are borrowing $180,000 from the bank. The loan-to-value ratio on your mortgage would then be 90%.

The ratio is used for several types of loans, including home and auto loans, and for both purchases and refinances.

LTVs are part of a bigger picture that includes:

  • Your credit score 
  • Your income available to make monthly payments
  • The condition and quality of the asset you’re buying

It’s easier to get higher LTV loans with good credit. In addition to your credit, one of the most important things lenders look at is your debt-to-income ratio, your debt payments divided by your income. This is a quick way for them to figure out how affordable any new loan will be for you. Can you comfortably take on those extra monthly payments, or are you getting in over your head?

How Loan-to-Value Ratios Work 

The more money a lender gives you, the higher your LTV ratio and the more risk they’re taking. If you’re considered a higher risk for the lender, this usually means:

  1. It’s harder to get approved for loans.
  2. You might have to pay a higher interest rate.
  3. You might have to pay additional costs, such as mortgage insurance.

You’re probably dealing with a loan that’s secured by some type of collateral if you’re calculating LTV. For example, the loan is secured by a lien on the house when you borrow money to buy a home. The lender can take possession of the house and sell it through foreclosure if you fail to make payments. The same goes for auto loans—your car can be repossessed if you stop making payments.

Lenders don’t really want to take your property. They just want some reassurance that they’ll get their money back one way or the other if you default. They can sell the property at less than top dollar to recover their funds if they lend only up to 80% of the property’s value.

Lending 100% or more puts lenders at risk if your property loses value after you buy it.

You’re also more likely to value your property and keep making payments when you’ve put more of your own money into the purchase.

The loan is larger than the value of the asset securing the loan when the LTV ratio is higher than 100%. You have negative equity in that case. You’d actually have to pay something to sell the asset—you wouldn’t get any money out of the deal. These types of loans are often called “underwater” loans.

How Do You Calculate Loan-to-Value Ratio? 

Divide the amount of the loan by the appraised value of the asset securing the loan to arrive at the LTV ratio.

Loan Amount/Appraised value of the asset = LTV

As an example, assume you want to buy a home with a fair market value of $100,000. You have $20,000 available for a down payment, so you’ll need to borrow $80,000.

Your LTV ratio would be 80%, because the dollar amount of the loan is 80% of the value of the house, and $80,000 divided by $100,000 equals 0.80 or 80%.

You can find LTV ratio calculators online to help you figure out more complicated cases, such as those including more than one mortgage or lien.

Acceptable LTV Ratios 

Something close to 80% is usually the magic number with home loans. You’ll generally have to get private mortgage insurance (PMI) to protect your lender if you borrow more than 80% of a home’s value. That’s an extra expense, but you can often cancel the insurance once you get below 80% LTV.

Another notable number is 97%. Some lenders allow you to buy with 3% down (FHA loans require 3.5%), but you’ll pay mortgage insurance, possibly for the life of the loan.

LTV ratios often go higher with auto loans, but lenders can set limits or maximums and change your rates depending on how high your LTV ratio will be. In some cases, you can even borrow at more than 100% LTV, because the value of cars can decline more sharply than other types of assets.

You’re using your home’s value and effectively increasing your LTV ratio when you take out a home equity loan. Your LTV will decrease if your home gains value because housing prices rise, although you might need an appraisal to prove it. You can sometimes use the land you’re building on as equity for a construction loan if you’re borrowing money to build a new home.