As a potential homebuyer, you may have heard that you have to have a good loan-to-value ratio (LTV) to qualify for a mortgage. Wondering what that means? A loan-to-value ratio is the number you get when you compare a loan amount to the value of the property or home.
What Is the Loan-to-Value Ratio?
- Loan-to-value ratio = Mortgage loan balance/home value
The loan-to-value (LTV) ratio is how much you’re borrowing from a lender as a percentage of your home’s appraised value. You can calculate your LTV ratio by taking your mortgage loan balance and dividing it by the appraised value of your property.
For example, if you’re buying a $300,000 home and taking out a $250,000 loan, the LTV ratio would be 83.3%. The loan-to-value math is 250,000 divided by 300,000 multiplied by 100 to find the final percentage.
Your LTV ratio depends on the size of your down payment. It matters because it’s what mortgage lenders use when assessing the risk of a potential borrower.
Why LTV is Important
The higher your LTV ratio, the riskier you’ll appear during the mortgage loan underwriting process. Why? When you make a low down payment, you have less equity (or ownership) in your home and you’re more likely to default on your mortgage loan.
If you can’t keep up with your mortgage payments and you’re forced into foreclose, your mortgage lender may have a hard time earning enough money from the home sale to pay off your remaining loan balance. That’s why homebuyers with high LTV ratios often get stuck with high mortgage rates.
What Exactly Is a Good Loan-to-Value Ratio?
What’s considered a good LTV ratio varies depending on the type of loan you’re applying for.
Conventional Homebuyers Need a 80% LTV
If you’re applying for a conventional mortgage loan, a decent LTV ratio is 80%. That’s because many lenders expect borrowers to pay at least 20% of their home’s value upfront as a down payment.
FHA Loans Allow 90% to 96.5% LTV
Mortgage loans backed by the Federal Housing Authority (FHA) come with a different set of rules. For homebuyers who are trying to qualify for an FHA loan, an acceptable loan-to-value ratio is 96.5% if your credit score is at least 580. If your credit score falls between 500 and 579, your LTV ratio can’t be higher than 90%.
For example, if you’re buying a home that’s appraised at $200,000, your loan can’t be more than $180,000. That means a minimum $20,000 down payment so that you stay at 90% LTV ratio.
USDA Loans and VA Loans Allow 100% LTV
If you’re applying for a loan that doesn’t require a down payment (like a USDA loan or VA loan), your LTV ratio can be as high as 100%. Of course, you’ll need to meet other qualifications in order to be eligible for those kinds of mortgages, such as income requirements and property location rules or veteran status.
Refinancing a Loan LTV
Borrowers who are refinancing may or may not need a specific LTV ratio. For example, if you’re refinancing through the federal Home Affordable Refinance Program (HARP), your LTV ratio must be higher than 80%. But if you’re interested in an FHA streamline refinance, there are no LTV ratio limits.
If Your Loan-to-Value Ratio Is Too High
Having a high LTV ratio can affect a homebuyer in a couple of different ways. For one thing, if your LTV ratio is higher than 80% and you’re trying to get approved for a conventional mortgage, you’ll have to pay private mortgage insurance (PMI). Fortunately, you’ll eventually be able to get rid of your PMI as you pay down your mortgage. Your lender must terminate it automatically when your LTV ratio drops to 78% or you reach the halfway point in your amortization schedule.
If your LTV ratio is too high, taking out a mortgage loan will also be more expensive. By making a low down payment, you’ll need a bigger loan. In addition to paying PMI, you’ll probably pay more interest.
A high LTV ratio can prevent a homeowner for qualifying for a refinance loan. Unless you can qualify for a special program (like HARP or the FHA Streamline refinance program), you’ll likely need to work on building equity in your home.
The loan-to-value ratio is just one tool that mortgage lenders use when deciding whether to approve a borrower for a mortgage or refinance loan. There are other factors that lenders take into account, such as credit scores. But if you want a low mortgage rate (and you want to avoid paying PMI), it’s best to make a sizable down payment and aim for a low loan-to-value ratio.
For help budgeting so you can make a sizable down payment, consider working with a financial advisor. A financial advisor can help you analyze your full financial situation and define your goals. SmartAsset’s financial advisor matching tool makes it easier to find an advisor who suits your needs. Simply answer a series of questions about your financial situation and preferences, and then the program will pair you with up to three financial advisors in your area.
Tips for Decreasing Your Loan-to-Value Ratio
- This is obvious, but needs the emphasis: increasing your down payment will decrease your LTV. That might mean waiting to buy a home until you increase your funds; or, it could mean finding a down payment grant or assistance program. Some first-time homebuyer programs offer grants or loans to qualified buyers. It’s worth checking out what your local city and state might have available.
- If you don’t have much down payment savings, you do have some zero down payment options. While it’s not ideal to buy a home without any equity, there are a few ways to do it if necessary.
Photo credit: ©iStock.com/DragonImages, ©iStock.com/SIphotography, ©iStock.com/kali9