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Loan-to-value (LTV) ratio is a number lenders use to determine how much risk they're taking on with a secured loan. It states the percentage of the securing asset, such as a house or car, the lender is willing to finance.
LTV ratio is especially important when it comes to mortgages. In fact, the federal agency that oversees mortgages specifies LTV limits that must be met in order to conform to its requirements. Here's what you need to know about LTV ratio, how to calculate it and why lenders value it so highly.
What Is a Loan-to-Value Ratio?
LTV ratio is a metric lenders use to compare a loan amount to the value of the asset purchased with the loan. For example, if a lender provides a loan worth half the value of the asset while the buyer covers the rest in cash, the LTV is 50%. LTV also reveals how much equity you have in your home by showing how much money would be left over after selling your home and paying off your loan.
Lenders generally consider higher LTVs to be riskier because their potential loss would be greater. Consequently, lenders often mitigate their risk by charging higher interest rates on your mortgage loan, and vice versa—a lower LTV could lead to a more favorable mortgage rate. Additionally, lenders typically require you to carry mortgage insurance if your LTV is over 80%.
How to Calculate Your Loan-to-Value Ratio
To determine your LTV ratio, divide the loan amount by the value of the asset, and then multiply by 100 to get a percentage:
Amount owed on the loan
Appraised value of asset
If you're buying a house appraised at $400,000 and your loan amount is $300,000, your LTV ratio at the time of purchase is: ($300,000 / $400,000) x 100, which equals 75%.
In other words, the LTV is the portion of the property's appraised value that isn't covered by your down payment. If you put 15% down on a loan that covers the rest of the purchase price, the LTV is 85%.
Lenders and federal housing regulators are most concerned with LTV ratio at the time the loan is issued, but you can calculate LTV at any time during the loan's repayment period by dividing the amount owed on the loan by the property's appraised value. 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 contributes to a reduced LTV. But if the property's value drops, that can push LTV higher.
What Is a Good LTV Ratio?
As a general rule, the lower your LTV ratio, the better. If you're taking out a conventional home loan, an LTV ratio of 80% or less allows you to avoid mortgage insurance, which can add tens of thousands of dollars to your payments over the life of your mortgage loan.
Some government-backed mortgages allow you to get away with very high LTV ratios. For example, the minimum down payment for a Federal Housing Administration (FHA) loan is 3.5% (LTV ratio of 96.5%). Certain loans, including those through the U.S. Department of Agriculture and the Department of Veterans Affairs don't require any down payment at all (100% LTV). Those loans typically require a form of mortgage insurance, however, or include extra fees to offset the risk connected with their higher LTVs.
LTV ratio is a less crucial factor with auto loans. While you might pay higher interest on a car loan with a higher LTV ratio, there's no threshold comparable to the 80% LTV that earns the best mortgage loan terms.
When an LTV ratio is greater than 100%, a borrower is considered underwater on the loan. Being underwater, or "upside-down," on your mortgage is when the balance on the loan is higher than the property's market value. LTVs greater than 100% are also possible early in the repayment period on loans with high closing costs.
How to Lower Your LTV Ratio
Generally, the lower your LTV, the less risk you pose to the lender since you're borrowing less and investing more of your own money into the home purchase. Consequently, a lower LTV may lead to a lower mortgage rate, which could save you significantly over time.
Because there are only two variables that determine LTV ratio—the loan amount and the value of the asset—the approaches to reducing LTV are pretty straightforward.
Make a Large Down Payment
For example, if you make a $40,000 down payment on a home appraised for $200,000, your LTV ratio on the $160,000 loan would be 80%, good enough to qualify for most home loans.
However, if you can make a $50,000 down payment on the same home, your LTV would fall to 75% on a $150,000 loan, which might result in a lower interest rate. In this case, if the lender lowers your mortgage rate from, say, 7% to 6.5%, you'd save nearly $42,000 in interest charges over the course of a 30-year loan.
Choose a More Affordable Home
If your budget is tight, consider purchasing a less expensive home to lower your LTV and potentially more favorable loan options. For example, if you have $40,000 for a down payment, shopping for homes in the $200,000 price range would line you up for an 80% LTV. Not only would you save by avoiding mortgage insurance, but you should also be able to avoid a high-LTV loan and the elevated interest rates that could come with it.
Make Extra Loan Payments
Periodically making an extra loan payment on top of your regular monthly mortgage can increase your home equity and lower your LTV. Even making one extra mortgage payment a year can lower your LTV and your overall interest charges, but remember to have your loan servicer apply the extra amount to the principal balance.
One way to make an extra payment each year is to apply your income tax refund or work bonus toward your principal balance. Another effective method—if your lender allows it—is to make half-payments on your mortgage every two weeks. Since there are 52 weeks in the year, you'd make 26 half-payments, equal to 13 full payments every 12 months.
Low LTV and Good Credit May Improve Approval Odds
A lower LTV ratio may help you qualify for a mortgage at more favorable interest rates while making your loan more affordable. Keep in mind, however, that LTV is just one of many factors lenders consider when approving a new mortgage loan.
Lenders also want to see you have sufficient income to support the payments on a new loan. Your creditworthiness also plays a significant role in lending decisions. Before applying for a mortgage, consider checking your credit report and credit score for free with Experian to see where your credit stands. If necessary, address any issues you find to improve your credit score and increase your chances of loan approval.