Are you thinking about taking out a home loan or refinancing your mortgage? If so, what is your loan-to-value (LTV) ratio? Understanding your LTV is an essential piece of the mortgage puzzle. And by taking the time to bring yourself up to speed on concepts like loan-to-value ratio, you’ll have a much better understanding of not only the mortgage origination process, but of whether you’re getting a relatively good deal on your new or refinanced mortgage. Shopping for a new mortgage can be daunting, but familiarizing yourself with key terms might help quell the dread of choosing the wrong loan.
This is especially true if you’re a first-time home buyer who hasn’t been through the process before. And you’re not alone! No matter what you hear on the news, young people—specifically millennials—are not “killing” the real estate market. Last year, millennials made 34% of all real estate purchases , and 66% of those purchases were by first-time buyers.
Generation X, which is anyone ages 37 to 51, made 28% of all purchases in 2017. These levels are low, historically, but considering the increasing costs of homeownership, young people are still buying when they can—even if only to avoid increasing rental prices.
When it comes to LTV, we’ve got you covered. We’ll break down what it is, how to calculate LTV using the loan-to-value formula, and most importantly, why LTV matters. (Hint: It could help save you a lot of money.)
What is loan-to-value ratio?
LTV is a ratio used to show the value of the property in relation to the value of the outstanding loan on that property. Said another way, it’s a way to look at the positive (or negative) net equity in your home. LTV is one of many factors that a bank considers when determining the interest rate for your home loan.
How do you calculate LTV?
To find the loan-to-value ratio, divide the loan value by the value of the property.
LTV = Loan Value / Property Value
Here’s an example: Say you want to buy a $200,000 home, and you have $20,000 set aside as a down payment. That means you would need to take out a $180,000 mortgage. So here’s what your LTV calculation looks like:
$180,000 / $200,000 = .9 or 90%
(Generally, you’ll see LTV ratios expressed as a percentage.)
Why does LTV matter?
There are two major components of your mortgage loan that can be impacted by your LTV: home loan interest rates and private mortgage insurance.
Income Rates
Analyzed in conjunction with other factors such as your income, personal financial history, and credit score, the LTV is a major factor in determining how much a loan will cost the borrower.
Why? Lenders use LTV to gauge risk. Someone with a higher LTV poses more risk to a lender. 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 they lent. Because of this, lenders prefer borrowers with lower LTVs and will 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. Same goes for a refinance or home equity line of credit; If you’ve got 20% equity ownership in your home, or at least 80% LTV, you’ll get a more competitive rate. And 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:
● 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:
● 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
Person Two will pay $84,113 more in interest than Person One, though it is true that Person Two also has a larger loan and pays more in interest because of that. So, let’s compare apples to apples: Let’s assume that Person Two is also putting $60,000 down and taking out a $240,000 loan, but that loan interest rate remains at 5.5%. Now, Person Two pays $250,571 in interest; That means the 1% difference in interest rates means paying an additional $50,000 over the life of the loan.
Private mortgage insurance (PMI)
Additionally, your LTV ratio determines whether you’ll be required to pay for private mortgage insurance (PMI). PMI protects your lender in the event that your house is foreclosed on a and the lender assumes a loss in the process. Your lender will charge you for PMI until your LTV reaches 78% or 80%. PMI can be a substantial added cost, ranging from .5% to 1% of the value of the loan per year. Using our example from above, a $270,000 loan could generate an annual PMI bill of up to $2,700, or $225 per month.
How does LTV change?
LTV changes when either the value of the property or the value of the loan changes.
The value of your property will fluctuate due to 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 property’s 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 larger payment toward your mortgage, that would of course significantly lower your LTV.
Whether through an increase in your property value or by reducing the loan, decreasing your LTV provides you with some money-saving options. First, once your LTV gets to 80% or lower, you can request that your PMI be removed. Also, you might find it beneficial to refinance to a lower rate once your LTV decreases. Refinancing your mortgage means starting over with a new lender and new terms, hopefully at a lower interest rate. As always, the specific terms of the loan will depend on the lender. Whether you’re on the hunt for a new home loan or a refinanced mortgage, it’s a good idea to shop around to find the best deal from a lender you trust.
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