The loan-to-value ratio (LTV) is a measurement that expresses the ratio of a first mortgage debt to the value of a home. For example, if you wanted to borrow $150,000 to buy a $200,000 home, the LTV ratio would be 75 percent. How is this factored into borrowing decisions?
How Lenders Judge Your LTV
When a lender is considering whether or not to approve a borrower for a loan, their foremost concern is the risk of default. Should a homeowner default on a loan, the house is sold, the debtor is paid the balance of the loan and the homeowner receives the remaining proceeds from the sale.
The LTV is a way to figure out how much risk of loss the lender is facing should the borrower default on the loan. The higher the LTV, the more likely a debtor is to face a loss if the borrower defaults. A lower LTV means less risk and possibly better mortgage rates for the borrower.
Many lenders will require borrowers to purchase mortgage insurance if their LTV for a particular home is too high. Mortgage insurance helps protect the lender in the event that borrower defaults. Essentially, the borrower pays the cost for the extra risk assumed by the lender, in the form of an increased mortgage payment to foot the bill for the premiums.
Combined Loan to Value Ratio
Another term you might hear is combined-loan-to-value ratio (CLTV). The CLTV accounts for any and all outstanding loan balances levied against the home. Here’s an example:
Let’s say you purchased a home above for $200,000 with a mortgage of $150,000. Ten years down the road, your home value has appreciated to $225,000 and your loan balance has dropped to $125,000. Your CLTV is about 55 percent.
You walk into your bank seeking a 15-year home equity loan of $50,000 for an addition to your home. The lender will add that potential debt to your outstanding balance to arrive at a total debt of $175,000. They’ll then calculate that against your most current home value (still $225,000) for a CLTV of 78 percent (still below the industry typical 80 percnet cut-off for mortgage insurance).
Five years later, you decide to take out a third loan against your home to begin a small business. Along with personal savings you’ve been stuffing away for a few years, you estimate you’ll need approximately $75,000 in start-up expenditures and a cash cushion to pay your first employees for the first few months.
At this point, the outstanding balance on your first mortgage is down to $110,000 and the balance on that second loan is down to $35,000. Between five more years of appreciation and the value added to your home when the renovations were complete, your home value now stands at $315,000. Your total debt, were you approved for your new loan, would be $220,000. Against your home value of $315,000, this would give a CLTV of about 70 percent.
(These numbers offer a simple math illustration of how your CLTV can shift over the life of a loan.)
Staying Under the LTV Limit
What does this mean to a potential homebuyer? The magic number for LTV is 80 percent and below. Most lenders consider such an LTV low and are generally more willing to consider higher risk buyers if their LTV falls below 80 percent.
A low LTV also makes a borrower much less likely to face the possibility of paying mortgage insurance, an extra expense for which the borrower receives no tangible benefit. The only way to lower your LTV is to borrow less for the home. That means saving as much as you can for a down payment. If putting more money down keeps you from paying mortgage insurance, the long-term savings can be significant: rates on mortgage insurance can range from 1.5 to 6 percent of the principal of the loan each year.