The loan-to-value (LTV) ratio is a number lenders use to determine how much risk they're taking on if you're borrowing with a secured loan. It is commonly used by mortgage lenders.
A high LTV ratio is considered riskier than a low one. What's more, the LTV ratio on your loan directly affects your monthly payment and how much interest you will pay over the life of your loan, so the lower the LTV, the better.
How the Loan-to-Value Ratio Is Calculated
To determine your LTV ratio, you simply divide your loan amount by the value of the collateral asset. Let's say, for instance, that you're buying a house appraised at $250,000, and your loan amount is $225,000.
In this scenario, your LTV ratio is: $225,000 / $250,000 = 90%
If your LTV ratio is above 100%, you're considered "underwater" on the loan. This can happen when the loan's fees and closing costs exceed your down payment, or if the collateral asset has depreciated quickly.
For example, CoreLogic estimated that 24% of all residential properties with mortgages were underwater in the first quarter of 2010 as the housing crisis at the time destroyed home values.
When you're underwater, defaulting may not be enough to get you out of the loan entirely. Depending on the loan type and lender, you may have to pay back the difference between what you owed and what the lender received from repossessing and selling the asset.
Why Your Loan-to-Value Ratio Matters
If you default on a secured loan like a mortgage or auto loan, the lender will foreclose or repossess the home or car used as collateral and sell it to get its money back. If you have a high LTV ratio when you first borrowed, it's possible that the lender won't get enough from selling the asset to pay off your defaulted loan. This is especially the case if the car's value has depreciated rapidly or there's a downturn in the housing market.
Since a high LTV ratio means more risk to the lender, it can directly affect you in three ways:
1. Higher Interest Rate
Lenders use interest rates to mitigate the risks of lending to borrowers. The more risk a lender takes on, the higher the interest rate will be. This is why people with poor credit tend to pay higher interest rates than people with exceptional credit. If the LTV ratio is high on your loan, you can expect to pay a higher interest rate than if you were to make a bigger down payment.
2. Private Mortgage Insurance
If you're buying a house with a conventional mortgage—loans not insured by government agencies—charging a higher interest rate might not be enough for the mortgage lender. If your LTV ratio is above 80%, you may be required to pay private mortgage insurance (PMI) to ensure that the lender gets its money back if you default. PMI typically costs between 0.5% to 1% of the loan amount every year. So, if your loan is $225,000, you can expect to pay between $94 and $188 extra every month until your LTV ratio reaches 78%.
3. Higher Monthly Payment
Between a higher interest rate and PMI costs (on a mortgage only), you can expect a higher monthly payment if your LTV ratio is high. A higher monthly payment can not only restrict your cash flow, but it can also mean paying more interest over the life of the loan.
What Is a Good Loan-to-Value Ratio?
Depending on your loan type, the LTV ratio may or may not be a crucial factor in your loan terms. With an auto loan, for instance, there's no magic number you need to have to get the best loan terms. While you may pay a higher interest rate on a loan with a high LTV ratio, there's no gold standard like there is with mortgage loans.
If you're taking out a conventional loan to buy a home, an 80% LTV ratio or lower is ideal. Anything above 80% can trigger the PMI requirement, which can add hundreds if not thousands of dollars to your payments every year.
Some government-backed mortgage loans allow you to get away with a higher LTV ratio. For example, the minimum down payment for an FHA loan is 3.5%, and USDA and VA loans don't require any down payment at all. That said, these loans either charge a form of mortgage insurance or extra fees in addition to closing costs to mitigate the risk of a higher LTV ratio.
How to Score a Lower Loan-to-Value Ratio
Since the LTV ratio has only two variables—the loan amount and the value of the collateral asset—it's not too hard to understand how you can decrease it. Here are just a few ideas:
1. Make a Bigger Down Payment
It might take you a little while longer to save for a big down payment, but it can be worth it in the long run. Find areas in your budget where you can cut back and save more toward your goal. That said, it's important to be realistic. If it would take you an unreasonable number of years to save a 20% down payment on a home, it might be worth getting into a home sooner with a smaller down payment if it could improve your quality of life.
2. Buy Used Instead of New
A new car loses about 10% of its value the minute you drive it off the lot, according to Carfax, and it will lose another 10% in the first year and up to 60% over the first five years. To avoid dipping underwater on your way home, either have a big enough down payment to cover the instant depreciation or go with a used car that won't depreciate as quickly.
3. Purchase a More Affordable Home
It's important to have a budget when you begin house hunting, but avoid making your maximum price your target. Instead, make sure to consider less expensive homes that still offer all of the features you're looking for. This strategy can be especially helpful if you're on the cusp of a 20% down payment.
Whether you're applying for an auto loan or mortgage loan, it's important to understand how the LTV ratio affects you and how you can decrease it. With this knowledge in hand, you'll not only be able to score lower interest rates but also avoid some of the other costs that come with a high LTV ratio.