Financial institutions and other lenders use the loan-to-value (LTV) ratio to determine how much risk they’re taking on with a secured loan. Loan assessments with high LTV ratios are typically seen as higher-risk loans and may come with higher interest rates and could require the borrower to purchase mortgage insurance.
While the loan-to-value ratio can apply to any secured loan, it is most commonly used with mortgages. Investors can use the LTV ratio when making decisions about when to sell or refinance a property.
Understanding Loan-to-Value
Your loan-to-value ratio measures the difference between the loan amount and the market value of the asset securing the loan, such as a house.
Let’s say you purchase a property and put down 30%. This means you’re only borrowing 70% of the home’s value and your loan-to-value ratio is 70%. In other words, the more money you borrow, the higher your LTV ratio and the riskier you are.
While a high LTV does not exclude a borrower from being approved for a loan, lenders are more likely to offer a lower interest rate to borrowers when their LTV ratio is at or below 80%. Additionally, if the LTV ratio is at or above 80%, borrowers may be required to purchase private mortgage insurance (PMI). PMI rates can range from 0.5% to 1.5% of the loan amount on an annual basis.
How to Calculate Loan-to-Value
Calculating your loan-to-value ratio is straightforward. Take your total loan amount and divide it by the purchase price. If you’re refinancing, divide it by the appraised value. Multiply that number by 100 to get your percentage. If you’re purchasing a property and the appraised value is lower than the purchase price, then the LTV is based on the appraised value instead.
Loan-to-value ratio = Loan Amount Purchase Price or Appraised Value x 100
Here are a few examples:
Let’s say a property is listed for $500,000 but it’s appraised at $475,000. You put down $100,000 so your total loan amount is $400,000. Your loan-to-value ratio would be 84%.
Now, let’s say you’re refinancing your property, which was valued at $300,000 and the total amount remaining on your mortgage is $100,000. Your loan-to-value ratio would be 33%.
Why Your LTV Matters
A higher LTV means you’re seen as a riskier borrower. Most lenders also have a maximum LTV to qualify for a loan, which is typically the minimum down payment required. A high LTV can affect you in several ways:
- Higher interest rate: Over time, a higher rate means you pay more towards interest over time.
- PMI: If your LTV is too high, your lender may require you to purchase private mortgage insurance. This could increase your monthly mortgage payments.
- Refinancing: A high LTV could affect your ability to qualify for a refinance.
- Building equity: A higher LTV means you have less equity in your property.
Whenever you’re taking out a mortgage, it’s important to consider how your loan-to-value ratio can impact you financially. There are several ways that you can lower your LTV and start building equity immediately.
If possible, you can increase your down payment amount or lower your purchase price. Because real estate appreciates over time, the value may have gone up significantly within a few years of purchasing it. If you’re thinking of refinancing, a reappraisal may help in this situation.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
