What is loan-to-value (LTV) ratio?
Few people have the cash on hand to buy a house outright. The vast majority of homeowners need financing to cover the cost of real estate beyond the down payment. That’s just the nature of the housing market.
Despite the ubiquity of mortgage lending, the specific thought process lenders take to figure out how much money to loan borrowers can still seem shrouded in mystery. Sure, there are a few common benchmarks to point to — credit scores, income, available funds, etc. — but what else goes into these calculations?
One of the key criteria mortgage lenders weigh when considering an applicant is your loan-to-value (LTV) ratio. Knowing what your LTV is and what it means for your loan application prospects is extremely important for anyone looking to buy a house.
What does LTV mean?
A loan-to-value ratio measures what percentage of a real estate purchase comes from financing. Basically, lenders want to know how much of the total cost they’re loaning compared with the amount the borrower is paying. To do that, your lender compares the value of the property with the amount of the loan. The result: your LTV ratio.
How does LTV impact your mortgage?
A higher LTV could indicate a higher level of risk for the lender, and that’s never a good thing for either them or you. Many lenders are hesitant to approve loan applications with LTVs above certain thresholds.
What are those thresholds? It’s hard to say because LTV limits tend to vary from lender to lender. The type of loan you apply for will play a role as well, as some mortgages like FHA loans have much more flexible requirements when it comes to LTV.
As a borrower, you should aim to lower your LTV as much as possible to improve your mortgage prospects. Even if a lender gives the green light on your application, they will probably try to offset any risk of default by attaching a higher interest rate to your loan.
How is LTV calculated?
LTV is a relatively straightforward concept with massive implications for borrowers. Want to know your LTV ratio? Just use this simple formula:
(LA / PV) * 100 = LTV
In this case, “LA” refers to your loan amount and “PV” is the property value. Let’s quickly walk through each step you need to take to figure out LTV:
- Estimate your loan amount. In some cases, you might know exactly how much financing you’ll need, but in others you may have to do some guess work. You don’t have to be exact, just get a ballpark figure. You can always use an affordability calculator to help lay out your homebuying budget and get a sense of how much financing you’ll need.
- Determine the property value. Your lender will conduct a home appraisal to determine the market value for the home you are purchasing. But until that report comes back, you can use various listing sites and market comps to get a sense of the property value. It won’t be 100% accurate, but it’ll be close.
- Divide the loan amount by the property value. Pretty self-explanatory, right?
- Multiply by 100. If you want your LTV expressed as a percentage, you need to take this extra step.
How does that work in a real-world scenario? Here’s how it’d look if you were buying a $500,000 house with a 10% down payment option:
- Your loan amount is $450,000 since you’re using a $50,000 down payment option.
- We’ll assume the purchase price accurately reflects the market value of the home. So, the property value is $500,000. That won’t always be the case, though.
- Dividing 450,000 by 500,000 gets us 0.9.
- Multiplying 0.9 by 100 brings that nice round percentage: 90%.
Your LTV ratio in this scenario: 90%. In other words, your lender is financing 90% of the home’s market value.
What is a good LTV ratio?
While that 90% LTV ratio isn’t completely unusual, some lenders may balk at a loan with such a high LTV. Lenders will always prefer borrowers who are able to cover a larger share of the purchase price than those who require more extensive financing. That doesn’t necessarily mean your loan application will be rejected if your LTV ratio is above a certain threshold, but lower is always better.
As a general rule, borrowers should aim for LTV ratios no higher than 80% if you want to secure more favorable financing terms. That being said, don’t feel discouraged if you can’t crack that threshold. After all, saving up enough money to cover a 20% down payment on a house isn’t always feasible. You still have plenty of other options to consider, such as government-backed mortgages and various types of home loans.
Financing options for high LTV ratios
Depending on other factors, such as your credit history, existing debt and income, lenders may very well approve your loan application even with a high LTV. You’ll need to pay private mortgage insurance (PMI) each month until you’ve gained 20% equity in your home, but that could be a price worth paying to become a homeowner sooner rather than later.
But let’s say you’ve checked with a few different lenders and none of them are willing to extend a mortgage with your current LTV. What then? There are several loan programs you can use to get over this speedbump:
- FHA loans
- VA loans
- Fannie Mae HomeReady®
- Freddie Mac Home Possible®
The Federal Housing Administration (FHA) insures home loans extended by certain approved lenders. This lowers the financial risk that mortgage lenders take on, encouraging them to loosen their eligibility requirements. What does that mean for you? With an FHA loan, down payment options start at 3.5%. And that, in turn, would mean your LTV on that loan could be as high as 96.5%. It’s worth checking out if you’re not confident about securing a conventional mortgage with your credit history and available funds. Keep in mind that you’ll still need to pay PMI — and unlike conventional home loans, that PMI may last the entire life of the loan.
Not everyone can take advantage of VA loans, but if you’ve served in the armed forces, they could provide exactly the financing terms you need to buy a home. The most enticing offer: zero down-payment requirements. That’s right, eligible service members and spouses don’t need to put up any money at all using this program. And you don’t even have to pay PMI, either! If you meet the Department of Veteran Affairs’ eligibility requirements, you should absolutely consider a VA loan.
Fannie Mae HomeReady®
Like FHA loans, Fannie Mae’s HomeReady® program is aimed at helping more people with diverse financial situations secure a mortgage. In fact, borrowers may be able to get approved for a home loan option with an LTV ratio as high as 97% using HomeReady®. Fannie Mae also offers very flexible down payment and closing cost terms, letting borrowers pay for those expenses with grants, gifts and other money sources. Going this route, you may not need to put up any up-front cash yourself.
Freddie Mac Home Possible®
Freddie Mac’s Home Possible® program is almost like a mirror image of HomeReady®, accepting applicants with LTV ratio options up to 97%. There are some income requirements you need to meet to qualify, though. Freddie Mac limits eligibility to 80% of the Area Median Income (AMI). Aside from those restrictions, however, this could be a very appealing option to borrowers with high LTV ratios.
How can you lower your LTV ratio?
There’s no quick-and-easy way to reduce your LTV on a particular piece of property. If you’re dead-set on buying a specific house, your only option is to pony up more money for the down payment.
Otherwise, you can look elsewhere for less expensive homes that won’t require as much financing. That could mean expanding your home search to cover other neighborhoods or trimming back your must-have list. Especially in red-hot real estate markets, you may need to sacrifice some of your wants and accept a fixer-upper instead of a move-in ready home.
Your loan-to-value ratio calculates how much of a real estate transaction will come from financing. Mortgage lenders use LTV ratios to weigh risk when extending home loans. As such, your LTV will impact what financing terms you get and even if you’re approved for a loan at all.
Don’t be discouraged if your LTV is on the higher end, though. There are plenty of home loan programs that can help you secure a mortgage. And some lenders may still approve your application based on other criteria like your credit score and history of paying down debt. Still wondering what your LTV means for your homebuying prospects? Reach out to a qualified loan officer to talk through your mortgage options.