When taking out a loan to pay for certain assets, like a home or car, you might hear your lender talk about its loan-to-value ratio. Also called LTV, this percentage helps lenders mitigate their own risk and also ensures that borrowers are taking out the right loan in the context of their financial situation.
Loan-to-value ratio matters to both lenders and homeowners, and a lower value is best. Fortunately, it’s easy to calculate this number on your own.
The name may have given it away, but LTV is the ratio of your loan compared to the value of the asset it is used to purchase. In terms of getting a mortgage, LTV is the ratio of the loan amount you (the prospective homebuyer) want to borrow as a factor of the property’s actual market value.
Loan-to-value ratios are expressed as a percentage. Each lender will set its own LTV requirements; whether you’re trying to purchase a home, car, boat, or other tangible asset, you’ll only be able to borrow up to a certain amount in order to meet that maximum loan-to-value ratio limit.
Try to borrow beyond that, and you might be required to offer a larger down payment or even negotiate a lower purchase price in order to get approval.
Calculating a loan-to-value ratio is very simple. You just need to divide the loan amount by the market value of whatever you’re trying to purchase, then multiply by 100.
Let’s say a buyer wants to borrow $200,000 for a home with a current market value of $245,000. Their LTV on that mortgage loan would be 81.6%
200,000 / 245,000 = 0.816 → 0.816 x 100 = 81.6% LTV
If those numbers were reversed, though, and the buyer wanted to pay $245,000 for a home that was only worth $200,000, their LTV would be 122.5%
245,000 / 200,000 = 1.1225 → 1.225 x 100 = 122.5% LTV
From a lender’s perspective, loan-to-value is important because it limits the risk that the lender takes on by issuing the loan.
If a borrower defaults on a loan, the lender is able to seize whatever property acts as collateral on that loan. When it comes to a home mortgage loan, for instance, a lender can foreclose on a house and sell it elsewhere to recoup their losses. If the homeowner owes more on their loan than the value of the home, however, the bank isn’t able to recover their losses entirely.
Let’s see this in numbers:
To avoid this situation, lenders are particular about the maximum LTV they are willing to accept.
From a buyer’s perspective, maintaining a reasonable loan-to-value ratio on a home allows a homeowner to maintain some equity in it. If they need to sell the property at any time, that equity helps ensure that they walk away from the transaction without owing the bank money out-of-pocket.
Here’s another example of LTV in action:
To avoid this situation, homeowners should always aim to maintain a reasonable loan-to-value ratio in their property.
Arguably, the best loan-to-value ratio is the one that’s the lowest. This serves to protect both the lender and the homeowner in a slew of situations.
If you’re wondering what LTV you should aim for when taking out a loan, though, the answer really depends on the type of loan you’re seeking and even the specific lender.
When it comes to mortgage loans, here are the common LTV requirements.
Borrowers may find that the higher their home’s LTV, the higher the interest rate they are offered on their home loan. (Find out what else affects mortgage rates.)
Loan-to-value ratios are also important when buying or refinancing an auto loan. While this can also vary by lender and even the age or the type of vehicle being purchased, the maximum LTV allowed by auto lenders is usually around 130%.
If you take out a conventional home mortgage loan with an LTV of more than 80%, your lender will typically require the purchase of private mortgage insurance. Also called PMI, this insurance protects the lender in case you default on your mortgage loan.
Borrowers can be required to pay PMI — which usually costs between 0.2% and 2% of the total loan amount each year — until their remaining principal balance reaches 78% to 80% of the loan’s original LTV.
There are many times where you may want, or need, to lower your loan-to-value ratio. But how?
If you are looking to buy a home, you can lower the LTV on your mortgage loan by doing the following:
If you already own a home, but find that your loan-to-value ratio is higher than you’re comfortable with, here are some ways you can work to reduce it:
Maintaining a reasonable loan-to-value ratio can protect borrowers and lenders alike. Owing too much on a particular asset is always a risk, so borrowers should do what they can to lower their LTV as much as possible.
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