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When you buy a home for the first time, you’ll have to learn a whole new set of financial terms and concepts. You’ll see acronyms like ARM (adjustable rate mortgage), DTI (debt-to-income), PITI (principal, interest, taxes, and insurance), and LTV (loan-to-value), making the home-buying process feel a bit like eating alphabet soup.
We’ll give you a full breakdown of what LTV is, how the LTV ratio works, and why it significantly impacts your mortgage financing. Then, you can use that knowledge when preparing your finances, shopping for a new mortgage, or assessing your current home loan.
Your loan-to-value ratio, or LTV, is an eligibility assessment that shows how much you owe on your mortgage versus how much your home is worth, expressed as a percentage. Lenders view this percentage as an indicator of the level of risk they undertake when issuing or refinancing a mortgage. A higher LTV often means a greater risk for the lender.
For home buyers, your LTV ratio is a direct result of the size of your down payment. For instance, if you put down 10%, your LTV is 90%. A 20% down payment gives you an 80% LTV. The lower your LTV, the more equity you have in your home.
Many home buyers think they need to make a down payment of at least 20% (an 80% LTV) to get a mortgage. However, that’s not the case. Fannie Mae and Freddie Mac offer conventional home loan programs – HomeReady and HomeOne®, respectively – which allow you to buy a house with as little as 3% down, or a maximum LTV of 97%.
Acceptable LTV ratios vary by mortgage type. Here’s what you can expect at a glance when purchasing your home:
Your LTV ratio is one of several indicators mortgage lenders consider when determining your eligibility for approval.
“The higher the LTV, the greater the risk of default, and the lower the chance of a lender being able to recover all of their investment in the event of a foreclosure,” said Casey Fleming, author of The Loan Guide, via email.
Therefore, your LTV helps to determine not just your mortgage eligibility but also the cost of the mortgage if you are approved. For example, if you have a high LTV, your lender may charge a higher interest rate as compensation for their risk.
On a 30-year $500,000 mortgage, a rate increase from 7% to 7.25% would raise your monthly payment by about $84 but boost your total interest costs by over $30,000.
A higher interest rate isn’t the only added cost of a high LTV. For conventional mortgages, you’ll need to pay for private mortgage insurance (PMI), which protects your lender if you default on your mortgage if your LTV is higher than 80%.
Depending upon your credit score, PMI typically runs between 0.46% to 1.50% of your base loan amount each year. So, if you borrow $500,000 with a PMI rate of 1%, you’ll pay an additional $5,000 annually (roughly $417 per month) until you can cancel the coverage.
Tip: If you take out an FHA loan, you must pay both upfront and annual FHA mortgage insurance premiums. Unless your LTV was 90% or less on closing day, mortgage insurance is required on FHA loans for the life of the mortgage.
You can calculate your initial LTV in two easy steps:
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Divide your mortgage amount by the sale price
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Multiply the result by 100 to arrive at your loan-to-value percentage
Here’s the formula in action: You put a $100,000 down payment on a $600,000 home. When you divide the $500,000 mortgage amount by the $600,000 sale price, you get 0.83, which is 83% once multiplied by 100. Your LTV is 83%, and you have 17% equity in your home.
Tip: The calculation shifts slightly when you refinance your property. Instead of dividing your mortgage amount by the sale price, you’d divide it by the appraised value. You may be able to refinance your primary residence with an LTV as high as 95%. However, you’ll need a lower LTV to refinance a second home or investment property.
Combined LTV, or CLTV, is a calculation that factors in all of the loans you have on a property. For example, let’s say your home is worth $500,000. You owe $150,000 on your primary mortgage and $50,000 on a home equity loan for a total of $200,000. Your CLTV is 40% ($200,000/$500,000 X 100).
When buying a home, the main thing you can do to lower your LTV is increase your down payment.
For homeowners, making monthly payments on time, home-price appreciation, as well as making improvements to your home, are all things that will naturally pay down your loan and increase your home’s value, thereby improving your LTV ratio.
Tip: If you can’t afford a large enough down payment, understand that your LTV will decrease naturally over time through monthly payments and home value increases. But if you want to speed up the process, consider making extra mortgage payments when possible.
While there can be a significant financial upside to having a low LTV, there may be instances where having a higher LTV makes sense for home buyers, such as:
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You may not have additional time to save for a down payment
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A lower down payment might allow you to accomplish other money-related goals, such as a hearty emergency fund or the opportunity to invest in other assets
Your LTV can greatly impact how much buying a house will cost you. However, it’s not the only thing you should consider when preparing for homeownership or a refinance. A strong credit score, the ability to contribute to a down payment above the minimum, and a steady income are among the many things you need to prepare for when the time is right to get a mortgage.