Coins and bills shaped like a house

Loan to value (LTV) is the difference between the fair market value of the home and the amount of your mortgage, typically when seeking financing, but applies throughout the life of the loan.

A mortgage is a secured loan, which means a loan that has collateral associated with it. The value of the asset is compared to the amount requested to determine loan-to-value. L

TV is used to determine the risk to the purchaser and financier. 


Importance of Loan-To-Value Ratio

The loan-to-value ratio is one of the important factors of a mortgage as this is the number lenders use to determine how big of a risk they want to take with a collateral loan.

The higher the LTV, the more costs the lender will need to recoup on a default. Lenders will use your credit history along with the LTV to determine the amount they’re willing to lend in general and specific to the house you’re purchasing.

Your interest rate will also be determined by credit history and LTV. 

Another impact that LTV has on your home purchase is in the form of closing costs. Typically, this is due to the costs increasing as they’re based on the amount of the loan.

Usually, if your LTV exceeds 80%, you also will be required to carry Mortgage Insurance, which is an insurance policy that covers the lender should you default on your loan.

And for some reason, if you need to resell the home early, you could easily lose money. 


Calculating Loan-To-Value Ratio

Calculating the loan-to-value ratio is pretty simple. You take the amount borrowed and divide it by the appraised value of the home.

For example, if you are buying a $200,000 home and you have $6,000 for a down payment. That would mean you are looking to borrow $194,000 on a $200,000 house.

Take that $194,000 and divide it by $200,000, and that would equal 0.97. Take 0.97 and multiply by 100, and you get a loan-to-value ratio of 97%. The calculation is relatively straightforward, but crucial in the home buying process. 


Loan-To-Value Ratio Affects Interest Rate

coins in front of a clock

We’ll begin this section with a discussion of risk-based pricing. Risk-based pricing is a strategy used by mortgage companies that consist of offering different interest rates based on the borrower’s creditworthiness.

Risk-based pricing takes into an account credit score, adverse items in credit history, and employment status including income. In using this methodology, lenders will also look at debt-to-income ratios (DTI) as well.

DTI is simply a ratio of your total debt payments compared to your monthly income. All of these factors in risk-based pricing combined with LTV will ultimately determine what your interest rate will be on a mortgage. 

The threshold at which private mortgage insurance (PMI) is required is typically 80%.

If the LTV is significantly higher than that, in the upper 90%s for example, you may have to pay PMI for the entire life of the loan, although typically the PMI is paid off in the first 10-12 years of the loan and then that payment will stop.

The annual cost of PMI is generally between 0.5% and 1% of the total loan. So on that same $194,000 loan, the yearly PMI would be between $957 and $1940, which would come out to between $79.75 and $161.67 per month. 


Lowering Your Loan-To-Value Ratio

There are many benefits to lowering your loan-to-value ratio. So the question then becomes how to do that or what’s the best way to accomplish this. The simplest way is to have a large down payment.

The more money you put down, the less the loan will be, and the lower the LTV. 

Are there other ways to lower LTV? One other way would be to negotiate the purchase price. If the home is appraised for $225,000, but you have negotiated the purchase price down to $200,000, that alone lowers the LTV.

The LTV usually is calculated using the appraised value, not purchase price. So in this scenario,

if you have $10,000 for a down payment on a purchase price of $200,000 for a house appraised at $225,000, your LTV would be $200,000 (purchase price) – $10,000 (down payment) which is $190,000.

Now, divide that by $225,000 and now you have an LTV of approximately 85%, versus 95%.

The final way would be to lower borrowing costs. Borrowing costs are the many fees associated with procuring a mortgage. The lender charges some, and some will be charged by third-parties such as appraisers, home inspectors, title companies, etc.

When shopping for a loan, ask upfront for the lenders’ closing costs. You can compare different companies and select the lower-cost one, considering all else being equal.

Conversely, you can attempt to negotiate with the lender on their costs. Shopping around and negotiating prices can be done to help mitigate any of the associated costs. 


Final Thoughts

Loan-to-value is one of the most important factors when determining your monthly payment on your new home. It’s a crucial component to know and understand when seeking a mortgage and a mortgage lender.

Different companies have different thresholds for what they’ll allow for LTV. And even within their allowable range, the closing costs and interest rates can vary greatly depending on what the LTV actually is.

Make sure you determine how LTV affects your mortgage before deciding on a lender.