Are you thinking about taking out a home loan or refinancing your mortgage? If so, knowing your loan-to-value (LTV) ratio, or the loan amount divided by the value of the property, is important.
Let’s break down LTV: what it is, how to calculate it, and why it matters. (Hint: It could help save you a lot of money.)
LTV, a Pertinent Percentage
The relationship between the loan amount and the value of the asset securing that loan constitutes LTV.
To find the loan-to-value ratio, divide the loan amount by the value of the property.
LTV = (Loan Value / Property Value) x 100
Here’s an example: Say you want to buy a $200,000 home. You have $20,000 set aside as a down payment and need to take out a $180,000 mortgage. So here’s what your LTV calculation looks like:
180,000 / 200,000 = 0.9 or 90%
Here’s another example: You want to refinance your mortgage (which means getting a new home loan, hopefully at a lower interest rate). Your home is valued at $350,000, and your mortgage balance is $220,000.
220,000 / 350,000 = 0.628 or 63%
As the LTV percentage increases, the risk to the lender increases.
Why Does LTV Matter?
Two major components of a mortgage loan can be affected by LTV: the interest rate and private mortgage insurance (PMI).
Interest Rate
LTV, in conjunction with your income, financial history, and credit score, is a major factor in determining how much a loan will cost.
When a lender writes a loan that is close to the value of the property, the perceived risk of default is higher because the borrower has little equity built up—and therefore, little to lose.
Should the property go into foreclosure, the lender may be unable to recoup the money it lent. Because of this, lenders prefer borrowers with lower LTVs and will often reward them with better interest rates.
Though a 20% down payment is not essential for loan approval, someone with an 80% LTV is likely to get a more competitive rate than a similar borrower with a 90% LTV.
The same goes for a refinance or home equity line of credit: If you have 20% equity in your home, or at least 80% LTV, you’re more likely to get a better rate.
If you’ve ever run the numbers on mortgage loans, you know that a rate difference of 1% could amount to thousands of dollars paid in interest over the life of the loan.
Let’s look at an example, where two people are applying for loans on identical $300,000 properties.
Person One, Barb:
• Puts 20%, or $60,000, down, so their LTV is 80%. (240,000 / 300,000 = 80%)
• Gets approved for a 4.5% interest rate on a 30-year fixed-rate mortgage
• Will pay $197,778 in interest over the life of the loan
Person Two, Bill:
• Puts 10%, or $30,000, down, so their LTV is 90%. (270,000 / 300,000 = 90%)
• Gets approved for a 5.5% interest rate on a 30-year fixed-rate mortgage
• Will pay $281,891 in interest over the life of the loan
Bill will pay $84,113 more in interest than Barb, though it is true that Bill also has a larger loan and pays more in interest because of that.
So let’s compare apples to apples: Let’s assume that Bill is also putting $60,000 down and taking out a $240,000 loan, but that loan interest rate remains at 5.5%. Now, Bill pays $250,571 in interest;
The 1% difference in interest rates means Bill will pay nearly $53,000 more over the life of the loan than Barb will.
PMI or Private Mortgage Insurance
Your LTV ratio also determines whether you’ll be required to pay for PMI. PMI protects your lender in the event that your house is foreclosed on and the lender assumes a loss in the process.
Your lender will charge you for PMI until your LTV reaches 78% (by law, if payments are current) or 80% (by request).
PMI can be a substantial added cost, ranging from 0.5% to 2.25% of the value of the loan per year. Using our example from above, a $270,000 loan at 5.5% with a 1% PMI rate translates to $225 per month for PMI, or about $18,800 in PMI paid until 20% equity is reached.
How Does LTV Change?
LTV changes when either the value of the property or the value of the loan changes.
If you’re a homeowner, the value of your property fluctuates with natural market pressures. If you thought the value of your home increased significantly since your last appraisal, you could have another appraisal done. You could also potentially increase your home value through remodels or additions.
The balance of your loan should decrease over time as you make monthly mortgage payments, and this will lower your LTV. If you made a large payment toward your mortgage, that would significantly lower your LTV.
Whether through an increase in your property value or by reducing the loan, decreasing your LTV provides you with at least two possible money-saving options: removal of PMI and refinancing to a lower rate.
The Takeaway
The loan-to-value ratio affects two big components of a mortgage loan: the interest rate and private mortgage insurance. A lower LTV percentage typically translates into more borrower benefits.
Whether you’re on the hunt for a new home loan or a refinanced mortgage, it’s a good idea to shop around for the best deal. Check out what SoFi has to offer.
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