The Loan-to-value ratio (LTV) is a calculation that measures how much you need to pay for a mortgage (loan) concerning how much the asset is worth. The loan-to-value ratio in real estate is used by financing institutions to calculate the risk of lending to a buyer before approving a mortgage. Usually, if an LTV ratio is high, the risk itself is considered more heightened by the financing institutions, leading to higher interest rates on the mortgage.
Any homebuyer may need to calculate their loan-to-value ratio, as purchasing a house might require a mortgage. The loan-to-value ratio is an essential process of mortgage underwriting, and financing institutions use it when a homebuyer wants to purchase a home, to refinance a mortgage into a new loan, or to borrow against the equity accumulated within the property.
In real estate, it is important to determine the “value” part of the loan-to-value ratio. To find the value, you should use the appraised value of the home at the time of closing. So, to calculate the loan-to-value ratio (LTV), all you need to do is figure out the amount of mortgage you have yet to pay and divide by the appraised value of your home. The result is put in percentage defining how much of the property you have already paid (home equity) and how much you still need to pay.
If you are interested in buying a property with an appraised value of $100,000 and you have $30,000 for your down payment, your mortgage, the amount you need to borrow will be $70,000. In this scenario, the loan-to-value ratio is 70%.
Lenders usually use the Loan-to-value ratio (LTV) during the underwriting process or when refinancing a current mortgage into a new loan. They use it to assess if the loan is risky for them or not. The ideal situation is to have the lowest percentage you can, as lenders will likely give you a better interest rate connected with your loan. If a borrower requests a loan that is close to the actual value of the property, the appraisal value, lenders consider it a risky endeavor, and the lender to have a higher chance of defaulting the loan. The higher the equity built up, down payment in the scenario above, the bigger chances for lower interest rates and avoidance of defaulting the loan. With little equity, if the house is foreclosed, the lender risks not covering the outstanding mortgage on a sale and profit from that transaction.
Lenders also use the loan-to-value ratio when calculating the interest rate for the loan. Having a higher LTV ratio doesn’t mean that borrowers won’t be approved for a mortgage. It only means that their interest rate might be higher as the risk the lender takes is increased. It’s said that anything below 80% will provide you with excellent rates. Plus, when it’s over 80%, the mortgage companies will likely obligate you to acquire Private Mortgage Insurance (PMI), so their risk is diminished. This expense for the borrower can add around 0.5% to 1% to the loan annually. The PMI payments are no longer required once the loan-to-value ratio drops below 80%, and the LTV ratio is reduced with every monthly payment. As a general rule, the lower the LTV ratio is, the higher the chance for a loan to be approved at lower interest rates. Also, with a low LTV ratio, there likely won’t be any need for a PMI.
Let’s see a practical example to better understand the concept: Homebuyer Laura got a $75,000 mortgage so that she could pay a $100,000 home. Her Loan-to-value ratio (LTV) is calculated by dividing 75,000 by 100,000, which would be 0.75 or 75%, a good ratio that will give her excellent interest rates and no need for PMI.
Loan-to-value ratio = mortgage amount / appraised value of the property
Real Estate tips:
Find a real estate agent and let him/her do the math for you!