What Is Loan-to-Value and Why Does it Matter?
Loan-to-value ratio compares the size of a loan used to finance an asset with the value of that asset. It’s commonly considered when you take out a mortgage to purchase a home. If you get a $400,000 home loan for a $500,000 house, for example, your LTV is 80%.
LTV can have a major impact on whether you're approved for a loan and the interest rates and terms you get on that loan. The higher your ratio is, the more risk the lender takes on by lending you money. It may charge a higher interest rate to compensate – or possibly even deny your application if your creditworthiness is in question.
Knowing how to calculate LTV and how it affects various loans is essential if you want to save as much money as possible when borrowing. In some cases, however, a high LTV can be worth it.
What Is LTV?
LTV indicates what percentage of a purchase you're financing with an asset-secured loan. LTV in its simplest form is how much protection the lender has on the value of the property, says Kevin Leibowitz, founder of New York-based Grayton Mortgage and a mortgage broker.
Lenders use the loan-to-value ratio along with other factors to determine the risk of a loan. A high LTV signifies more risk because if you default on the loan, it's less likely that the lender will get enough money by repossessing and selling the asset to cover the remaining loan amount and the costs associated with the process.
"The more money you put down, the less risky you are as the borrower," says Dave Lowell, certified financial planner and founder of Up Your Money Game, a financial coaching and education company based in Utah. "So you'll tend to get a lower interest rate."
When you first apply for a loan, you can reduce the initial LTV by making a down payment or, in the case of an auto purchase, trading in another vehicle as part of the sale. In general, a loan's LTV decreases as you make payments toward its principal amount.
If you have good or excellent credit, your history of responsible credit use and on-time payments can help mitigate some of the risk a lender takes on with a high-LTV loan. And depending on your overall creditworthiness, you may still manage to get the loan at a favorable rate.
But if your credit isn't in great shape, you may have a hard time getting approved with a decent rate unless you can find a way to reduce the LTV significantly.
How to Calculate LTV
You can calculate loan-to-value by dividing the loan amount by the value of the asset. Here's the simple formula:
LTV = loan amount / value of asset
Multiply the resulting decimal by 100 to turn it into a percentage. For example, if you're buying a home and the loan amount is $250,000, while the value of the home is $275,000, your LTV is roughly 91%.
What Is Combined LTV?
A combined loan-to-value ratio, or CLTV, is used when you have more than one loan on a property. For example, if you decide to take out a home equity loan, lenders will take the combination of your primary mortgage loan and the proposed home equity loan to determine your eligibility.
Most lenders allow a maximum CLTV of 85%, but some may go as high as 100%.
What Is a Good LTV?
Mortgage experts generally agree that a good LTV is 80% or lower. This is particularly true for conventional loans, which typically require private mortgage insurance if your LTV exceeds 80%. This addition to your monthly payment can cost between 0.3% and 1.5% of your loan amount annually.
On a $250,000 loan, that's between $62.50 and $312.50 added to your monthly mortgage payment.
You may also explore government-insured loans, such as Federal Housing Administration loans, which allow an LTV up to 96.5%. U.S. Department of Agriculture and U.S. Department of Veterans Affairs loans offer up to 100% financing.
Keep in mind, though, that a high LTV can come back to bite you. If the value of your house falls, you could end up underwater on the loan, owing more than it's worth. If this occurs, it can be difficult to sell the property or refinance your loan.
Loan-to-Value Ratios by Loan Type
Here are the LTV requirements for various types of home loans:
TYPE OF HOME LOAN
Conventional home loan
Federal Housing Administration loan
96.5%, depending on your credit
Department of Veterans Affairs loan
U.S. Department of Agriculture loan
Home loan refinance
- It may be possible to take out a conventional home loan with a down payment as low as 3%. You’ll have to pay PMI for a while, but moving forward may be worth it in a low-interest-rate environment.
- FHA loans allow a down payment as low as 3.5%, so your LTV could be up to 96.5%. However, borrowers with credit scores below 580 have to put down at least 10%, resulting in an FHA loan with an LTV of at most 90%.
- Eligible borrowers may qualify for a VA or USDA loan with zero down payment, meaning the loan would provide 100% financing (and have a 100% LTV).
- If you wish to refinance your conventional mortgage, most lenders want to see that you have at least 5% equity in your home. However, you’ll likely get better rates if you have 20% equity and get a refinance loan with a maximum LTV of 80%.
How Does LTV Affect Your Interest Rate?
A higher LTV may result in a higher interest rate. This is because the lender is taking on more risk in the agreement.
Even a small increase in your rate can impact your long-term costs significantly. For example, let's say you have a $250,000 loan that you're paying back over 30 years and your interest rate is 8%. With these terms, you'll pay $1,834 toward principal and interest per month and $410,853 in interest over the life of the loan.
But if your high LTV results in a 8.5% interest rate instead, your monthly payment and total interest charges would increase by $88 and more than $31,000, respectively.
If you're applying for a secured loan, ask the lender how the interest rate changes if you decide to put more or less down on the purchase.
Having a high LTV could still make sense in some situations:
The new loan will save you money
If paying rent is more expensive than making a mortgage payment, says Leibowitz, getting into a home before you have a big down payment could be worth it.
"For those that aren't putting a large percentage down, the most important thing to ask," Leibowitz adds, "is 'Can I afford my mortgage payment, real estate taxes and insurance afterward? Am I comfortable with this payment going forward?'"
A home loan with a low down payment could also make sense if interest rates are low and expected to rise in the future. You can also cancel PMI once you’ve reached 20% equity, which could happen sooner in an area where home values are going up.
You want a hefty emergency fund
Making a significant down payment can reduce your interest rate on a loan. But if you drain your savings account, it can make you financially vulnerable.
"A lot of people view the LTV as an absolute. You never want to do mortgage insurance, it's a waste of money," says Leibowitz. "But it's not the entire part of the story. You've got to make sure that you have enough reserves, and ask, 'What does my financial picture look like after I buy this place?'"
If you put all of your cash toward a home and then you need cash to cover emergency expenses, you can't get that money back from the lender.
You can get more value from the cash elsewhere
If you're getting a low-interest loan, you may get more value by using some of the money you were thinking of putting down and investing it instead.
For example, if having a higher LTV increases your loan from 3.5% to 3.75% and you can get a 7% to 8% average annual return in the stock market, it may not be worth it to put all the money toward the loan.
In today's high-interest-rate environment the opposite could be true: Putting more towards a down payment could help lower your interest rate and make payments more affordable.
How to Lower Your LTV
Whether you're about to make a purchase using a secured loan or you already have one in place, here are some ways to reduce your LTV:
Make a larger down payment
Your LTV is based on your loan amount and the value of your home or vehicle. By putting down more money when you apply for the loan, you'll immediately start out with a lower LTV.
Buy a more affordable home or car
If you can't put more money down – or even if you can – you may consider a more budget-friendly option. By looking for a more affordable home or vehicle, the same down payment will reduce the LTV even more.
Make additional payments
You can do this by adding some money to your monthly payment; paying half the amount due every two weeks, giving you one full extra monthly payment every year; or putting small windfalls like tax refunds and performance bonuses toward your balance.
Over time, the value of your home should appreciate, and your payments will reduce the principal value of the loan, both of which will consistently reduce your LTV. This process goes more slowly than the other options, but it happens naturally even if you don't do anything extra.
If you have a conventional mortgage with private mortgage insurance, once you cross the 80% LTV threshold, you can celebrate – you don't need to pay for PMI anymore.