The Loan-to-Value (LTV) ratio is defined as the outstanding amount on your mortgage divided by the appraised value of your property. Whether you are buying or refinancing a home, considering a home equity loan, or preparing to take on some other form of long-term debt, the LTV ratio is important to you.
The LTV ratio is one of the primary factors lenders use in considering mortgage approval. In essence, it represents part of your risk of defaulting on the loan. If you have a second mortgage or a home equity loan on the property, it may be expressed as the CLTV for cumulative LTV number.
For a new homebuyer, the LTV is directly reduced by down payment. The typical down payment requirement for conventional mortgages is 20% of the value of the house, thus making your LTV ratio 80%. For a refinancing, the loan portion is calculated using the amount you still owe (the outstanding principal, excluding interest).
With less than 20% down payment, you are likely to fail to qualify or pay higher interest rates unless you have outstanding credit. Even then, you will probably be required to pay Private Mortgage Insurance (PMI). The new Qualified Mortgage rules from the Consumer Finance Protection Bureau (CFPB) have caused lenders to scrutinize the ability to repay in greater detail. You can check your credit score and read your credit report for free within minutes using MoneyTips' Credit Manager.
It is still possible to get loans with lower down payments and LTV values of 90% and above through federal programs such as FHA and VA loans, and the HARP program that focuses on refinancing. The HARP program was designed especially to allow underwater homeowners (with LTV's greater than 100%) to refinance to improve their terms.
Because of the way mortgages are structured, new homeowners pay very little on their principal in the early days of the loan. In the recent housing crisis, the collapse of prices dramatically dropped the value of their homes. This double whammy left some homeowners underwater (owing more in principal than the house was worth).
For example, with a $250,000 home, if the principal were spread evenly over a 30-year loan, the monthly principal payment would be $694.44 (considerably less than the interest portion of the payment using today's rates near 4.3%). In one year, you would pay $8333.28 in principal, leaving your loan amount at $241,666.72.
If the value of your house dropped only 3.5% during that year to $241,250, you would have a LTV of 1.002 – and you would be officially underwater. For reference, during the first quarter of 2011, home prices dropped 3%.
Lenders and regulators are attempting to keep people from overextending themselves, and giving greater scrutiny to the LTV ratio as a result. How can you avoid falling into this trap when buying or refinancing?
- More Down Payment – If you cannot afford a 20% down payment, consider that you may be buying more home than you can afford.
- Pay Principal Ahead – Paying extra toward the principal every so often not only lowers your LTV but also saves significant interest.
- Watch Appraisals – Monitor home prices over time. If home prices rise, or you complete home improvements that raise the value of your home, this by definition lowers your LTV. Keep in mind it is a balance – if your home value rises, your LTV lowers, but your property taxes may also rise.
- Consider an FHA-Insured Loan – FHA mortgages can be obtained with as little as 3.5% down and are insured by the federal government. This allows you buy a home with a much higher LTV ratio, but you must pay costly FHA mortgage insurance. This is an option one should consider with care.
Even if you are not looking for loans, it is wise to keep tabs on your LTV just in case you need to borrow money in the future. That way, if your LTV doesn't suit your needs, you have time to address it and make changes.