When it comes to homeshopping, the purchase price isn’t the only figure to pay attention to.
The median home price in the U.S. hit $405,000 in March 2022 — an all-time high. Rising home values also affect a key metric called the loan-to-value ratio (LTV). Lenders use a borrower’s LTV to assess the financial risk they take on before approving a mortgage. The higher the LTV, the higher the risk which can affect what type of mortgage you can get to the interest rate.
With home values increasing, the money you have saved for a down payment won’t cover as large of a percentage of the purchase price. That means more homebuyers could find themselves with higher LTV ratios, which could negatively affect a loan’s terms and overall cost.
“The number one priority for a consumer is, what can I afford? What do I feel comfortable with?” said Chuck Meier, SVP and mortgage sales director at Sunrise Banks.
In order to fully understand what you can afford, you’ll need to understand what your expected loan-to-value ratio is, and what it means for the overall cost of your loan.
What Is Loan-to-Value (LTV) Ratio?
“A loan-to-value ratio is the percentage of the loan amount [compared] to the lower of the appraised value or the purchase price,” said Nicole Rueth, producing branch manager for The Rueth Team at Fairway Independent Mortgage Corp.
In other words, LTV is the relationship between how much the home is worth and the mortgage amount. For example, if you have a 20% down payment, that means your mortgage covers 80% of the home value, and your LTV is 80%.
“It’s super important for the lender,” Rueth said, because the minimum loan to value ratio varies by the type of loan. It also helps a mortgage lender determine risk — the less money you put down, the higher your LTV, the riskier the loan — and set interest rates and terms accordingly.
How to Calculate LTV
The loan-to-value ratio is a simple calculation.You’ll need the loan amount (i.e. the total value of your mortgage) and the purchase price of the home, or the appraised value, whichever is lower.
This is the equation:
Loan to Value Ratio = Mortgage Amount / Property Value
Let’s look at an example. If your home value is $400,000 and your down payment is 10%, you’ll have a loan balance of $360,000. Your loan-to-value equation is $360,000 / $400,000, which is a 90% LTV ratio.
How the LTV Ratio Affects Your Mortgage
The loan-to-value ratio is a key consideration for lenders when they are figuring out which mortgage programs you qualify for. The LTV ratio determines your eligibility for different types of mortgages that have different LTV thresholds.
Don’t assume what types of loans you qualify for. Talk to a lender to see what mortgages and loan-to-value ratios are a good fit for you.
The LTV ratio is also used to determine whether you qualify for a home equity loan or home equity line of credit (HELOC), because lenders are usually not willing to lend more than 80% of the home value.
More importantly, however, lenders use the LTV ratio to determine your risk profile.
“The lender wants a specific loan-to-value because they want you to have, in layman’s terms, skin in the game,” Rueth said.
Generally speaking, a higher LTV ratio is seen as riskier, because you have less money invested in the home. In the event of a foreclosure, the lender stands to lose more money the larger your loan. One way mortgage lenders offset the risk is with higher interest rate.
Lenders also hedge that risk by requiring private mortgage insurance (PMI), which is generally applied to all loans with higher than an 80% LTV ratio. The cost of PMI varies depending on factors such as your outstanding mortgage balance and credit score. Private mortgage insurance can add $30 to $70 per $100,000 to your monthly mortgage payment.
“The higher the loan to value, the greater the cost to the borrower,” said Meier. “It’s a big deal.”
But don’t forget, Rueth advises, that private mortgage insurance can be taken off a loan once you reach 20% equity in your home, which is when your loan to value drops to 80%.
Loan-to-Value Rules for Different Mortgage Types
Each type of mortgage has different LTV ratio requirements. The rules can be confusing when you’re first starting out, which is why Rueth says you should consult a professional about your specific situation.
“Don’t assume you know the answer before you talk to the lender,” Rueth said.
Meier agrees: “The number one thing for them to do first and foremost is to meet with the loan officer at their bank,” he said.
Here are the basic LTV ratio requirements for each type of loan:
The maximum LTV ratio for a conventional loan is 97% if you’re a first-time homebuyer, which means you can put as little as 3% down. If you’re not a first-time buyer, the maximum LTV is 95%, according to Rueth.
Home loans backed by Freddie Mac and Fannie Mae are also known as conventional loans.
An FHA loan, which is a government-backed mortgage popular with low-income or first-time buyers, allows for a maximum LTV of 96.5%, meaning a down payment as low as 3.5%. All FHA loans, regardless of LTV ratio, require mortgage insurance.
VA and USDA Loans
The other two popular government loans are VA loans and USDA mortgages. These both allow for up to 100% LTV, which means you could put 0% down to purchase a home. There are other requirements for these loans, which limit who’s eligible, but they’re worth considering if you qualify.