What is a loan-to-value ratio?

A loan-to-value (LTV) ratio is a lending risk assessment used by mortgage loan lenders in order to calculate their exposure to a chance of default.

Generally, the higher an applicant’s loan-to-value ratio, the riskier it is for a mortgage loan lender to offer financing to the borrower in question. As far as anyone interested in borrowing a mortgage loan should be concerned, lower loan-to-value ratios make for easier monthly payments.

Greg Cook, First Time Home Buyer and Certified Military Housing Specialist for First Time Home Buyers Network, told loans.org that loan-to-value ratios are determined by dividing the proposed mortgage loan amount by the appraised value of the home. Different mortgage loan programs have different loan-to-value requirements, such as the FHA which limits a loan-to-value to 96.5 percent. VA loans on the other hand, permit a 100 percent loan-to-value ratio.

That means for a home worth $200,000, the FHA will only insure $193,000 (meaning the borrowers have to come up with the remaining $7,000 themselves), while the VA will guarantee the entire $200,000 amount.

These ratios aside, it is very important to understand that lenders desire borrowers to have more equity in the property they’re financing. The more equity, or ownership, a borrower has in a property — such as in the form of a down payment — the less likely they are to default on their mortgage loan payments.

David Hall, President of Shore Mortgage, showed loans.org a very simple example of how a loan-to-value ratio is calculated:

• A house is appraised at a value of $300,000.
• The mortgage loan amount for the house is $240,000.
• $240,000 divided by $300,000 equals 0.8, which means the borrower has an 80 percent loan-to-value ratio.

“Whether you are purchasing or refinancing a home, the LTV ratio is going to be very important,” said Hall. “As a mortgage lender we look at a client’s LTV to determine the amount of risk associated with a loan. The higher the LTV ratio, the higher the risk the mortgage lender would be taking with that loan. An LTV of 80 percent is usually the dividing point between high (above 80 percent) and low LTV (below 80 percent).”
Hall continued to explain that lower loan-to-value ratios typically result in lower interest rates because the borrowers are lower risk. When homeowners have loan-to-value ratios over 100 percent it means they owe more than their house is worth.

As a result, loan-to-value ratios can quickly prove expensive for prospective homeowners.

Joe Parsons, Senior Loan Officer for PFS California, told loans.org just how costly mortgage insurance can become.

“When a borrower has less than a 20 percent equity position, the lender will in almost all cases require mortgage insurance to limit their risk,” said Parsons. “A borrower with a credit score of 720 and a loan which is 90 percent of the property’s value will pay 0.49 percent mortgage insurance. This would amount to $122.00 per month on a $300,000 mortgage. The same borrower would pay insurance of $185 per month (.67 percent) for a 95 percent loan.”

The expensive possibility of paying insurance for a high loan-to-value ratio prompts the question: what other ways can a loan-to-value ratio hurt or help mortgage loan borrowers?

Jeffrey M. Sutton, Mortgage Loan Officer at George Mason Mortgage, told loans.org that every mortgage loan borrower is different and thus can be hurt or helped differently by different loan-to-value ratios.

“There may be a situation where [borrowers] might want to have more liquid cash available so having a higher LTV suits their needs,” said Sutton.  “Maybe they want to have a more affordable monthly payment so a lower LTV will help keep that payment at a more comfortable level.  There are many reasons that a higher LTV or a lower LTV make sense for someone.  The key is to get a broad picture of what the borrower’s goals are so you match them up for what makes sense for them.”

Now that the economy is recovering, people may have more money and more goals—such as the desire to own a home — than they did in recent years.

Steven M. Marche, President of Great American Funding, told loans.org that loan-to-value ratios have not changed despite the ongoing recovery. However, Fannie Mae and Freddie Mac’s requirements have been raised.

“Fannie Mae and Freddie Mac have gotten stricter regarding loan-to-values on condo and rentals up to 4 units,” said Marche.  “You can obtain higher LTV’s, however, they put a risk factor fee as you go higher in LTV.”

Marche said that he has noticed Fannie Mae now requires signed letters by borrowers explaining inquiries on their credit reports, even if the sole inquiry is from their mortgage loan lender.

Additionally, lenders now require the most recent week’s paystubs, even if a borrower is qualified for an amount three times the amount of the mortgage loan that was applied for. Lenders are also requiring letters of explanation for unusual deposits and even easily understood deposits such as Social Security.

“In my opinion, some of these redundant requirements are frustrating the borrowers, to the extent that they have told me, ‘We just do not need this loan that bad,’” said Marche.

Needed or not, borrowers must understand how a loan-to-value ratio affects their mortgage loan application as well as how lenders use these ratios to determine who should and shouldn’t be given home financing.