What Is Loan-to-Value Ratio?
Loan-to-value ratio (LTV) is a metric that banks and lenders use to determine the risk level of approving you for your loan. The LTV calculation is important to understand whether you’re looking to purchase a new home, refinancing your current mortgage, purchasing an investment property, or borrowing against the equity you’ve built up in your current home. Without the correct LTV, you can be turned down for your loan or be required to purchase things like private mortgage insurance (PMI) or pay higher interest payments.
What is LTV ratio?
Loan-to-value ratio is a simple calculation but a powerful financial metric that gives a quick snapshot of the potential risk associated with a loan. There are other factors considered by lenders when approving loans, but an LTV that does not fit into a predetermined range can be an instant deal-breaker.
The LTV ratio compares the size of the loan you’re applying for to the appraised value of the property. If you’re requesting a loan that is close to the appraised value of the property or even higher, there’s very little wiggle room there in the case that the market takes a turn south. On the flip side, if the property is appraised at a much higher amount than the size of the loan you are requesting, there is significantly less risk to the lenders. This is because the loan is using the property as collateral. If the loan size is larger than the value of the property, the lender would have issues getting its money back if it needed to sell the home.
Here’s a simple example. Let’s say a friend is looking to buy a collectible coin that is worth $50 that they think is a great deal, but they just don’t have the cash right now to pay for it. Your friend tells you they’re good for the money and if for any reason they can’t pay you back, you can have the coin. If they ask you for $48 to purchase it, you’d probably be skeptical of how great of a deal it is as they’re asking for almost as much money as the value of the coin. But if they asked you for $30 to get the coin that’s supposed to be worth $50, that would seem less risky for you.
Why? If they ended up being unable to pay you back for the coin, you would need to sell it to get your money. If you were, in fact, able to sell the coin for the appraised value of $50, this is no problem. But what happens if the coin loses value or you’re unable to move it for the full appraised value? Let’s say you’re only able to sell it for $45 to recoup your money. In the first example, you’ve now lost $3 on the deal. In the second example where the ratio of the loan amount to the value of the coin is lower, you’re going to turn a profit on the deal.
Loan-to-value ratio shows lenders how risky the loan will be in the off-hand chance the lender has to seize the collateral to repay the loan.
Calculating loan-to-value ratio
A better understanding of how the loan-to-value ratio is calculated will help you to see how lenders use this metric and why it is so important. Let’s take our earlier example of a coin purchase, translate it into a housing loan, and look at specifics. The formula for calculating the LTV ratio is as follows:
Loan-to-value ratio (LTV) = Loan or mortgage amount (MA) / Appraised property value (APV)
Let’s say you’re looking to purchase a home that is appraised at $150,000. The seller is looking to move the property quickly and is willing to sell the home for $130,000. Let’s calculate the LTV.
LTV = MA/APV
LTV = $130,000/$150,000
LTV = 0.867
To convert this into a percentage, multiply by 100. Your LTV for this purchase would be 86.7%.
The necessary LTV ratio that banks will approve loans depends on the bank. However, most banks won’t approve any mortgage loans for LTVs greater than 80%. If this is the case, how would you go about lowering your LTV go get approval for your mortgage loan?
There are two main ways you can do this — you can look to lower the sale price of the home, or you can make a down payment.
In our above example, let’s say you’re able to convince the seller to sell you the home for $120,000. The LTV is now:
LTV = MA/APV
LTV = $120,000/$150,000
LTV = 0.80
Multiply this by 100 to get the percentage, and you get 80%. While this would be the ideal way to get a lower LTV, sellers are not always willing to drop the price on the home. This is when down payments become important.
Let’s say the seller in this scenario is holding firm at $130,000. By making a down payment on the house, you’ll reduce the size of the loan you need. By paying a $10,000 down payment, you now will only need $120,000 to complete the purchase of the home. If you calculate the LTV now, it also comes out to 80% and is within the acceptable range for approval.
Why loan-to-value is important
The reason loan-to-value ratio is important to you is simple — it’s a requirement by most banks to be in a certain range for your loan request. For the banks and lenders, the metric is important because it helps to better assess the inherent risk of the loan you’re applying for.
LTV can have an effect on the interest rate you’re charged. Loans that carry less risk generally have lower interest rates. It can also determine the need for additional costs like private mortgage insurance (PMI) or mortgage insurance premiums (MPI). A firm understanding of this calculation and the numbers that go into it can help you to save a lot of money in the long run.
The final word
When you’re purchasing a home, refinancing, or making any major financial move, you need to ensure you understand everything that is happening. Loan-to-value ratio is an important factor in determining interest rates and any other fees that may apply to a loan backed by property, such as a car or house. Understanding this will help you make sound financial decisions in the future.