What is a loan-to-value ratio and how is it calculated?
When it comes to obtaining a mortgage loan, understanding the loan-to-value ratio (LTV) is crucial. LTV is an essential factor as it directly impacts mortgage terms, interest rates, and even your loan approval.
What is loan-to-value ratio?
Loan-to-value ratio (LTV) is a financial metric that represents the proportion of a property’s value that is being financed through a mortgage and is expressed as a percentage. Essentially, LTV is a measure of the loan amount relative to the current value of a property.
To calculate a loan-to-value ratio, simply divide the mortgage amount by the current value of the property it’s financing and multiple that result by 100:
Loan-to-value Ratio = (Mortgage Amount ÷ Current Home Value) × 100
For example, if you are purchasing a property worth $400,000 and need a mortgage loan for $320,000, the LTV would be calculated as:
LTV = ($320,000 ÷ $400,000) × 100 = 80%
In this scenario, the LTV is 80%.
Significance to lenders
Lenders use the loan-to-value ratio as a tool to help assess risk when offering financing options to homebuyers. A higher LTV signifies there may be a higher risk in lending as the borrower has less equity invested in the property. Lower LTVs correspond to a lower level of risk for lenders because they indicate that a borrower has more equity in the property is considered less likely to default on the loan.
Lenders generally have maximum LTV thresholds that they are willing to accept for different loan types. For example, a lender may have a maximum LTV of 80% for a conventional mortgage. When working with that lender, a borrower should expect that a higher LTV than the specific threshold may result in additional requirements such as private mortgage insurance (PMI).
What is combined loan-to-value ratio?
Another important factor for lenders is the combined loan-to-value ratio (CLTV). This is the combined ratio of all loans secured by your home to the assessed value of your home. While LTV considers only your primary mortgage loan balance, CLTV considers the balance of all mortgages you have on a property or are looking to apply for. This may include loans such as home equity loans or home equity lines of credit (HELOCs).
For example, let’s say you want to tap into some of the equity you have in your home to access cash for a home renovation project. Assume that your home is valued at $400,000. If your current mortgage loan balance is at $300,000, you have $100,000 worth of equity in your home ($400,000 - $300,000 = $100,000). If you want to borrow $50,000 of that through a home equity loan, your CLTV would be:
($300,000 + $50,000) ÷ $400,000 = .875
Multiply that result by 100 to turn it into a percentage value, and you will have an 87.5% CLTV in this example.
Just like with LTV, lenders will establish maximum CLTV limits for borrowing. These limits may vary depending on your chosen lender or due to other factors like applicable state laws and regulations. If you are looking to apply for a second mortgage, make sure to research what options may be available to you before applying.
Discover® Home Loans offers low fixed rates on home equity loans with terms of 10, 15, 20, or 30 years up to 90% CLTV.
Significance of loan-to-value ratio for home equity loans and HELOCs
The 2008 financial crisis and its aftermath brought LTV and CLTV ratios into the spotlight — and made lenders more stringent when it comes to requirements for home equity loans and HELOCs. That’s because many lenders ended up underwriting loans for homes that were mortgaged for more than their market value (also known as being “underwater”).
When borrowers defaulted, secondary lenders were unable to recoup their money, as many foreclosures only recouped the lower value of the original loan. Today, home equity loans and LTVs/CLTVs are intertwined — banks and borrowers understand that maximum CLTV limits exist and borrowing anything below the limit is correlated a lower risk of loan default. While high CLTV loans and refinance opportunities exist, these may come with higher interest rates and stipulations including carrying mortgage insurance.
Knowing your LTV and CLTV ratios can help you understand your home equity loan and HELOC options — and may help determine how much of your equity you would like to borrow against to achieve your financial goals.
Factors impacting your loan-to-value ratios
While your LTV ratio lowers as you pay off more of your mortgage and establish more equity in your home, closing your home purchase with a low LTV may put you in a competitive position for refinancing and or other borrowing opportunities in the future.
Here are some factors to consider regarding your LTV:
- Down payment. Not only will a 20% down payment allow you to avoid private mortgage insurance, it will also ensure that you start your home ownership journey with a 80% LTV. This may allow you to increase your chances of earning approval for a home equity loan in the future.
- Home value. Getting the lowest sale price possible can positively affect your LTV, especially if you purchase a home below its perceived value and can take out a lower mortgage amount. Purchasing a home above its sale price and requiring a larger mortgage may mean that your LTV could start at a higher ratio than it would have if the buyer had accepted a lower bid.
- Appraised value. Maximizing the value of your home via home improvements, enhanced curb appeal, and general upkeep may lead to your home maintaining or increasing its value, which may help you keep your LTV low.
Understanding how LTV works can empower you to make financially savvy decisions during the home buying process. While you can’t control all factors related to LTV, know that the ratio will continue to be important throughout the life of your mortgage — especially if you wish to access a home equity loan or home equity line of credit.
LTVs and different loan types
Different loan types may have different rules when it comes to LTVs. That said, aiming for as low an LTV as possible can help ensure that you’re getting the most competitive loan rates.
- FHA Loans: A Federal Housing Loan (FHA) loan is a type of loan backed by the government for first-time buyers. This type of loan can require as little as 3.5% down payment, but these loans may require a Mortgage Insurance Premium (PMI) which can last for the life of your loan, regardless of your LTV. In addition, FHA loans may have stipulations regarding home equity loans. For these reasons, many homeowners use an FHA refinance once they have a certain amount of equity in the home.
- VA and USDA Loans: These government-backed mortgage options are available to certain members of the population. VA loans are available to many current and past service members and USDA loans are available to individuals who live in rural areas and hit certain eligibility criteria. Both mortgages have minimal down payment requirements. However, they may also have additional fees, as well as restrictions when it comes to refinancing and additional loans.
- Fannie Mae and Freddie Mac: For low-income borrowers, Fannie Mae and Freddie Mac mortgage offerings only require minimal down payments. However, they require homeowners to carry mortgage insurance (which can be cancelled once LTV falls below 80%). While these programs have refinancing options available, they will use LTV to determine loan eligibility.
Ways to lower LTV and increase home equity
A low LTV can keep you in a competitive position, regardless of your plans for a home equity loan or HELOC. The more equity in your home, the lower your LTV. Here are some ways to lower your LTV if you’re already a homeowner.
- Consider refinancing: If you’re able to do so, it may make sense to refinance your mortgage. Switching from a long-term, 30-year mortgage to a short-term, 15-year mortgage will increase monthly payments, but it will also pay your principal down more quickly and increase your home equity. Locking in lower interest rates for the same term can also reduce your overall interest charges over the life of the mortgage loan.
- Address necessary repairs: Staying on top of repairs and maintenance can increase the value of your home. Regular roof repairs, gutter cleaning, and painting will help maintain and potentially increase the value of your home. Curbside appeal counts, too: addressing any necessary exterior work, such as paving or landscaping, may maximize your home’s value and lower your LTV.
- Improve your property: This may sound implausible, especially considering that home equity loans are often used to address home improvement projects. But home improvements don’t need to be big to increase the value of your home. Simple improvements like repainting, adding insulation, and addressing any issues like mold, wiring, and plumbing may increase the value of your home.
- Pay more toward the principal: Yes, some mortgages have prepayment penalties. But that’s a bridge you can cross when you come to it. If your goal is to decrease your LTV, earmarking financial gifts, windfalls, and bonuses toward your mortgage will give you more equity in your home and may allow you to lock into the most competitive home equity loan rates.