The loan to value ratio (LTV) is a tool that lenders will use to review and dissect the mortgage application of the potential home buyer. For example, if the loan to value is high, the riskier it will be for the bank to supply the loan. If approved with a high LTV, the potential home buyer will likely have a higher interest rate as well.
Loan-to-value reviews the worth of the potential home buyer’s loan to the worth of the property. The home buyer's lender will then divide the loan amount by the purchase price or the appraised worth of the home, whichever is lower. This will enable the lender to reach the loan-to-value ratio. For example, if the home is appraised at $500,000 and you are requesting a $400,000 loan, the potential home buyer’s LTV would be around 75% of the loan.
The loan-to-value ratio is very important through the home buying process. When considering how much you are going to put down on a home, it is important to understand your LTV ratio because this will help the lender decide if the potential home buyer will be approved for the loan.
For example, let’s say that a potential home buyer puts less than 20% down on a home, which will cause the loan-to-value ratio to be higher than 80%. In this case, this would be a riskier loan and PMI or private mortgage insurance will be required to protect the loan in case of default. PMI is designed to protect any lender if the potential home buyer’s down payment is less than 20% of the loan. PMI can be removed once the equity in the home reaches 20%, otherwise PMI will stay with the mortgage and be divided into monthly payments until the loan is paid off. Private mortgage insurance can range anywhere from 0.22% to 1% of the total loan amount.
In addition, the loan-to-value ratio will be considered if the home owner ever decides to refinance the home. A home owner may choose to refinance because they want a lower payment, lower interest rate, or want a different loan type. Regardless of the reason, if the LTV ratio ends up being higher than 70% of the loan, the homeowner may want to reconsider the refinance as it may make the interest rate higher.
When applying for a loan, most potential home buyers will want to aim for a low loan-to-value ratio. A low LTV will be looked at more positively by a lender because the potential home buyer is viewed as less of a risk. However, if the potential home buyer has a high credit score coupled with a high LTV, the high LTV may balance out and the lender may look favorably at the loan application as well. When reviewing the loan application, the lender will examine the credit score, income, employment history, debt to income ratio, and how much of a down payment the potential home buyer can afford.