If you're buying a home and apply for a mortgage, one critical factor in whether you secure financing is your loan-to-value ratio. So what exactly is this LTV ratio?
An LTV ratio is simply the amount of money you borrow from your lender, divided by the purchase price of the home, expressed as a percentage. For example, let's say the home you have your eye on is worth $250,000 and you plan to make a down payment of 20% of the home's price, or $50,000. That would mean you need a loan for $200,000. That would also mean your LTV ratio would be $200,000 / $250,000 = 0.8, or 80%.
Why the loan-to-value ratio matters
Lenders use LTV ratios to determine the risk level they face loaning money to a prospective client. The higher a client's LTV, the greater the odds are deemed to be that this borrower might stop paying the monthly mortgage fees and default on the loan.
"Borrowers who have a higher loan-to-value ratio are considered more risky to lenders, because they have less equity in their homes," explains Keith Gumbinger, vice president of HSH.com, a mortgage information resource. In other words, they have less skin in the game.
For instance: Let's say you make a down payment of only 10%, or $25,000, on that home worth $250,000. That would mean you need a loan for $225,000, which would also mean your LTV ratio would be $225,000 / $250,000 = 0.9 or 90%.
Most conventional private lenders like banks require an LTV ratio of 80% (or lower) to approve a loan (which translates to buyers making a 20% down payment). Home buyers with a higher LTV (and lower down payment) might be deemed too risky and be denied a mortgage. Or, a lender might approve the loan, but at a higher interest rate (more risk, more reward), or require that the buyer purchase private mortgage insurance which will cover the lender should the borrower default. PMI is typically required for conventional loans with down payments of less than 20%.
How to lower your loan-to-value ratio
There are two ways to lower your LTV to get good terms on a home loan. The first is to make a larger down payment -- at least 20% will generally lower your LTV to within a range found to be desirable by lenders. The other strategy, of course, is to buy a cheaper house. So if you have only $25,000 for a down payment, buy a home worth $150,000. That would mean you'd need a loan for $125,000, and that your LTV would be $125,000 / 150,000 = 0.83, or 83%.
When in doubt, talk to a lender or Realtor to discuss your options -- ideally before you start house hunting so you know what's within your budget. You can also crunch the numbers with this mortgage calculator.
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