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Mortgage

Understanding Loan-to-Value Ratio (LTV)

Loan-to-value (LTV) ratio is a number lenders use to determine how much risk they're taking on with a secured loan. It measures the relationship between the loan amount and the market value of the asset securing the loan, such as a house or car.

If a lender provides a loan worth half the value of the asset, for example, the LTV is 50%. As LTV increases, the potential loss the lender will face if the borrower fails to repay the loan also rises, creating more risk.

Loan-to-value ratio can apply to any secured loan but is most commonly used with mortgages. In fact, several federal mortgage programs specify LTV limits as part of their qualifying criteria.

How to Calculate LTV

To determine your LTV ratio, divide the loan amount by the value of the asset, and then multiply by 100 to get a percentage:

LTV = (Amount owed on the loan ÷ Appraised value of asset) × 100

If you're buying a house appraised at $300,000 and your loan amount is $250,000, your LTV ratio at the time of purchase is: ($250,000/$300,000) x 100, which equals 83.3%.

In other words, the LTV ratio 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, then 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 reduces LTV. But if the property's value drops (if housing prices fall significantly in the local market, for instance), that can push LTV higher.

When an LTV ratio is greater than 100%, a borrower is considered "underwater" on the loan—that is, when the market value of the property is less than the balance owed on the loan. LTVs greater than 100% are also possible early in the repayment period, on loans with high closing costs.

How Does Loan-to-Value Ratio Affect Interest Rates?

U.S. lenders typically follow a practice known as "risk-based pricing," which involves setting higher interest rates on loans they determine to be relatively risky. This leads to borrowers with subpar credit being charged more than those with excellent credit, and it applies to LTV as well: Since a high LTV ratio means more risk to the lender, loans with high LTVs typically come with higher interest rates.

Higher interest rates aren't the only way in which a high LTV can cost you.

If you're buying a house with a conventional loan—that is, a mortgage that's not backed by a federal program—an LTV ratio greater than 80% may mean you're required to buy private mortgage insurance (PMI), which covers the lender against loss if you fail to repay your loan. PMI typically costs between 0.5% to 1% of the loan amount every year, and must be paid until your LTV ratio drops to 78%. So, if your loan is $250,000, you can expect to pay between $104 and $208 extra every month until that happens.

What Is a Good LTV?

If you're taking out a conventional loan to buy a home, an LTV ratio of 80% or less is ideal. Conventional mortgages with LTV ratios greater than 80% typically require PMI, which can add tens of thousands of dollars to your payments over the life of a 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%). Loans 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 forms of mortgage insurance or include extra fees in the closing costs 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.

How to Lower Your LTV

Generally speaking, reducing LTV on your loans, especially on mortgage loans, means lower total costs over the life of the loan. 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 larger down payment. Saving for a big down payment may test your patience if you're really eager to get into a house or car, but it can be worth it in the long run.
  • Set your sights on more affordable targets. Buying a home that's a little older or smaller than the house of your dreams could allow your current savings to serve as a larger portion of the purchase price.

Whether you're applying for an auto loan or a mortgage, it's important to understand how your LTV ratio affects overall borrowing costs, what you can do to decrease LTV, and how doing so can save you money over the lifetime of a loan.

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