Your loan-to-value (LTV) ratio is determined by dividing your loan amount by the value of the asset (such as a home or a vehicle) purchased with the loan.
It’s a good idea to know your LTV ratio since it is a primary factor a lender considers when you apply for a loan. The ratio directly affects your interest rate and your monthly payment as lenders typically deem a high LTV ratio to be riskier than a low LTV.
How Is Loan-to-Value Ratio Calculated?
To determine a loan-to-value ratio, the amount of the loan into the appraised value of the asset purchased with the loan.
For example, let’s say you want to purchase a home that is selling for its appraised value of $200,000. You have $40,000 to put down, which leaves $160,000 as the amount you would need to borrow.
To determine your LTV ratio, divide the loan amount ($160,000) by the appraised value of the property ($200,000), which is .80, or 80% in this case. The LTV is 80%, meaning the loan is 80% of the value of the property.
Why Loan-to-Value Ratio is Important
Lenders use LTV ratios to help them evaluate risk. These lenders might assume that customers with a better financial picture can afford a higher LTV ratio.
To that end, having a higher LTV can affect your loan in a number of ways:
- Loan Approval Is Harder
It’s harder to get approved for a loan if you have a high LTV ratio because it is more difficult for the lender to recoup their losses if you default on the loan.
For example, let’s say you apply for a home loan with an 80% loan-to-value ratio. In other words, the amount of the loan is only 80% of the current value of the property. If for some reason you are unable to repay the loan, the lender may sell the house at a discounted price to recover the funds.
On the other hand, if you try to get a loan for 100% or more of the property value, the lender is taking a considerably higher risk. That is why loan approvals are harder to obtain with a higher LTV ratio.
- Higher Interest Rates
To diminish the risk of lending money, lenders use interest rates. The higher the risk, the higher the interest rates lenders require from their borrowers. This is why borrowers with poor credit typically pay more in interest than borrowers with better credit.
It makes sense, then, if your LTV ratio is high, you may have to pay a higher interest rate than you would if your down payment was larger.
- Private Mortgage Insurance
When applying for a conventional mortgage loan, which is not insured by the government, the lender may want more than higher interest rates to mitigate their risk. They may also require private mortgage insurance (PMI).
PMI is an insurance policy that protects the lender from losing money if you default on your mortgage and they have to sell the house for less than you owed.
If your loan-to-value ratio is 80% or higher, PMI generally costs between 0.5% and 1% of the loan amount every year.
A higher loan-to-value ratio indicates you have less equity in the purchased asset.
Equity is important if you want to sell the asset and pay off the loan early. If for some reason you have a financial hardship, such as losing your job, and you need to reduce your monthly bills, you may find it hard to sell the asset for as much as you owe on the loan.
What Is a Good Loan-to-Value Ratio?
What is considered a good LTV ratio? The answer depends on the type of loan you are trying to get.
- Auto Loan LTV
Auto loans generally do not have a specific LTV ratio number you need to get good loan terms. Unlike mortgage loans, there is no benchmark loan-to-value ratio you need for an auto loan, but the higher your loan-to-value ratio may mean a higher interest rate.
- Conventional Mortgate Loan LTV
For conventional mortgage loans, 80% LTV or lower is recommended. . If you’re LTV is above 80%, the lender may require you to get PMI.
- FHA Mortgage LTV
The qualifications for a loan backed by the Federal Housing Authority (FHA) allow a loan-to-value ratio of up to 96.5% if your credit score is 580 or higher. If your credit score is in the 500 to 579 range, a 90% LTV is the maximum allowed.
How Can I Get a Lower Loan-to-Value Ratio?
As we’ve seen, some loans, such as those backed by the FHA, USDA and VA, allow for higher loan-to-value ratios. However, a higher LTV usually means a higher interest rate.
Here are a few ways to lower your LTV ratio:
- Save for a Bigger Down Payment
A simple way to lower your LTV ratio is to put down a larger down payment when you apply for a loan, even if it means waiting until you can save enough money.
- Wanting to Buy a Car, Look at a Used Car
According to Bankrate.com, most new cars lose 30% of their value during the initial year of ownership. If you don’t have enough of a down payment to cover the first year of ownership, consider buying a used car to avoid owing more than the car is worth.
- Choose a More Affordable Home
To avoid paying private mortgage insurance and higher interest rates, you might consider less expensive homes that still feature everything you’re looking for. This strategy may lower your LTV and be the difference if you’re trying to clear the 80% LTV hurdle.
- Have Your Home Reappraised
If property values are rising in your area, or if you’ve made significant improvements to your home, the value of your house may be higher than when you purchased it. In that case, you may want a new appraisal, especially if you’re applying for a home equity loan or line of credit.
The Bottom Line
The Loan-to-value ratio is important but it’s only one part of the picture. To get approved for a loan with good terms, credit scores and reports, debt-to-income ratio, and other factors are also important.
Still, LTV is important if you want a lower interest rate on a loan. For home loans, a lower LTV may even help you avoid PMI.
Don’t rush into a loan if you don’t have a reasonable down payment. Take your time and aim for a bigger down payment and a lower LTV ratio.