Whether you’re shopping for a home now or expect to in the future, knowing what a loan-to-value ratio is and why it’s important can help prepare you for a property purchase. Loan-to-value is a financial metric that compares the amount of a loan to the value of the asset you’re purchasing.
Here’s an easy example: You’re buying a house worth $100,000 and intend to pay for it by using $25,000 of your own money, borrowing the rest from your lender. In this scenario, the loan amount is $75,000 and the property value is $100,000, so your loan-to-value ratio is 75%.
When you apply for a mortgage, your loan-to-value ratio is an important factor that might save you money or get your loan application rejected.
- The Importance of Loan-to-Value Ratios
- How Does Your Loan-To-Value Ratio Affect Different Types of Loans?
- How Is Loan-to-Value Calculated?
- What Are the Limitations of Loan-to-Value?
- Refinance Options for High Loan-to-Value Ratios
The Importance of Loan-to-Value Ratios
When you apply for a loan, the lender will look at your home appraisal and consider your loan-to-value ratio before making a decision. The lower the loan-to-value ratio is, the likelier you are to get a better mortgage rate. Because borrowers with lower loan-to-value ratios have more equity in their properties, lenders consider them less risky and less likely to default on the mortgage.
Equity is money that you’ve paid into a property, whether upfront as a down payment or over time through monthly mortgage payments. For example, if you buy a $400,000 home by paying $100,000 from your savings account and borrowing the remaining $300,000 from your lender, your loan-to-value ratio would be 75%, and your equity would also be 75%. After some years of making your monthly mortgage payments, the balance of your loan will eventually get down to $200,000, which means you’ll have 50% equity in your house.
Borrowers with a low loan-to-value ratio get the best mortgage rate because they are considered low risk. If they default on their payments, the lender will have a better chance of selling the home for the balance of the mortgage. When you have a high loan-to-value ratio, banks will consider you more of a risk and will typically offer you higher rates.
How Does Your Loan-To-Value Ratio Affect Different Types of Loans?
When you have a high loan-to-value ratio, your lender might require you to obtain private mortgage insurance to cover you if you default on your loan. You’ll need insurance for conventional loans unless you put down at least 20% of the home’s value. The rates for this insurance vary by carrier, but the higher the loan-to-value, the more costly the insurance.
If you’re getting a loan from the U.S. Department of Agriculture (USDA), your loan-to-value ratio won’t make a difference — the USDA allows up to 100% financing and charges a flat upfront insurance fee of 1% of the loan amount and a monthly charge of 0.35%.
Similarly, if you are getting a Veterans Affairs (VA) loan, your loan-to-value ratio won’t affect you because the VA offers 100% financing. And while the agency charges a flat funding fee, it doesn’t make you obtain mortgage insurance. If you’re getting a loan that’s insured by the Federal Housing Administration (FHA), the mortgage insurance premium will vary from 0.55% to 1.05% based on the loan type, term, amount and loan-to-value ratio.
The maximum allowed loan-to-value varies by loan type. Here are some examples:
- Conventional: 97%
- USDA: 100%
- VA: 100%
- FHA: 97.75%
How Is Loan-to-Value Calculated?
To calculate your loan-to-value ratio, divide your loan amount by the home’s appraised value. The equation is simple and looks like this:
LOAN AMOUNT ÷ APPRAISED VALUE = LTV
If you have multiple mortgages on the same property, you must calculate your combined loan-to-value ratio. To do this, add both loan balances and divide that number by the current appraised value of the property.
LOAN 1 AMOUNT + LOAN 2 AMOUNT ÷ APPRAISED VALUE = LTV
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What Are the Limitations of Loan-to-Value?
Loan-to-value is a great risk-evaluation metric and protects lenders from losing their money when a borrower defaults on their mortgage. However, loan-to-value ratios are not a foolproof way of ensuring that an investment is safe. When the real estate market takes a heavy hit, homes could lose a significant amount of value and end up being worth less than the outstanding balance of the loan. Therefore, lending companies have to rely on other risk-related metrics such as credit scores and debt-to-income ratios.
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Refinance Options for High Loan-to-Value Ratios
If your loan-to-value ratio is higher than the above-mentioned limits, you’re probably “upside-down” on your mortgage, which means your house is worth less than your loan balance. If you’re in this situation, you might be able to refinance through one of the following programs:
- Freddie Mac’s Enhanced Relief Refinance
- Fannie Mae’s High Loan-to-Value Refinance Option
- FHA’s refinance programs if your existing loan is with the FHA
Each program has specific eligibility requirements, including being current on the existing loan. The programs are designed for homeowners who owe their lenders more money than their house is worth. In areas where the housing market drops significantly, these types of refinances are common.
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This article has been updated with additional reporting since its original publication.