What is Loan-to-Value Ratio?

If you plan on applying for a loan, it is helpful to have all the important information at your disposal. Here, we describe the loan-to-value ratio and how it affects both your ability to be approved and how much it will cost to take out a loan.

The loan-to-value ratio, often referred to as the LTV, is a financial term used by lenders to express the ratio of a loan to the value of a purchased asset. Most of the time, you will hear about the LTV ratio in relation to mortgage loans. Here's a concrete example: if you borrow $170,000 to buy a house worth $200,000, the LTV ratio is $170,000/$200,000, or 85%. In order to reach 100%, the remaining 15% is covered by your equity. As a quick rule of thumb, if the LTV ratio is high, the loan is considered riskier for the lender.

When lenders assess potential borrowers for a mortgage, they often consider the LTV ratio as one of the key risk factors. If the amount of equity decreases, the possibility that a borrower will default on the loan increases. A higher LTV ratio usually means there are stricter qualification guidelines for certain mortgage programs. In fact, if your LTV ratio is high enough, a lender can require you to purchase mortgage insurance as an added security measure in case you default. As you can imagine, having to pay for insurance increases the overall cost of the mortgage.

If a lender works with borrowers who are lower risk due to a low LTV ratio, typically below 80%, it frees up more money for the lender to take on higher-risk candidates. Higher-risk candidates are most often individuals with low credit scores, inconsistent payments in their mortgage history, and a low or nonexistent income, among other factors. On rare occasions, lenders will accept a LTV of 100%, meaning the loan is fully financed by the lending institution, but this option is only available to borrowers with a pristine credit history and typically only offered by the USDA, VA, and other lenders who deal with speciality loan types.

Higher Ratio Equals Higher Risk

It is important to note that the loan-to-value ratio is not comprehensive enough to be used as the only criteria when assessing loans, but it certainly sheds some light on the riskiness of any given loan transaction. Since high LTV ratios are generally seen as higher risk, if the mortgage is accepted, the borrower should expect to pay more in order to borrow the money. In other words, if you need to borrower a significant amount of money in order to afford the appraised value of the property you are interested in, the LTV ratio will be high and it will be harder to get a mortgage.

In order to decrease the risk on their end, lenders usually require a ratio at a maximum of 75% for a mortgage to be approved. Meaning, if you need to borrow $95,000 in order to buy a $100,000 property, a LTV ratio of 95% may make it difficult to get the extra funds. The value of the property is determined by the lesser of the home's appraised value or purchase price, if applicable.

If a borrower has an extremely high LTV ratio, over 100%, they are considered "upside-down" on their mortgage. In other words, the value of their home is less than their loan amount. Although this situation is not ideal, borrowers with an "upside-down" mortgage still have the option to refinance. There are special financing programs designed to help individuals with a LTV ratio over 100%.

Aim for a Low TTV Ratio

Finally, if you have a low loan-to-value ratio, meaning you have more equity in your property, the lender believes you are less likely to default on your loan. If you do happen to default and your home goes into foreclosure, the lender will have an easier time selling the property for at least as much as they are owed for the mortgage.

Here's the bottom line: when it comes to a mortgage loan, or any other type of loan that is based on the equity of a personal asset, strive for a low LTV ratio. You will be considered less risky to lenders and as a result, have an easier time borrowing money when you need it most.