• Tue. Sep 27th, 2022

What is the loan-to-value ratio? – Buy Side from WSJ

ByMadeleine J. Pierce

Aug 25, 2022

For anyone buying a home, your loan-to-value ratio is a key number. A measure of the size of your mortgage relative to the value of your home, your so-called LTV goes a long way in determining whether you qualify for a mortgage and what interest rate you’ll get. The same is true when you go to refinance a mortgage on your existing home and with other types of loans such as car loans.

Although it is relatively easy to calculate your LTV, the process can get tricky when making a volatile housing market, when home prices can quickly drift away from the appraised values ​​that lenders rely on. However, to get the most competitive mortgage rates, you should aim for a loan-to-value ratio of 80% or less. Here’s what you need to determine your loan-to-value ratio and how it affects your finances.

How to Calculate the Loan to Value Ratio

The loan-to-value ratio is a way of weighing a homeowner’s debts against the value of a home. Expressed as a percentage, the ratio is calculated by dividing the amount of money to be borrowed by the appraised value of the property. For example, if you buy a house for $400,000 at appraised value and need to borrow $320,000 (after an $80,000 down payment), your LTV ratio is 80%, also sometimes described as 80/20.

Although simple, the ratio is widely used as a quick and easy way to capture a household’s ability to meet mortgage payments, relative to the value of the home, says Ken Leon, director of equity research. at CFRA Research in New York.

Ultimately, lenders can use the LTV to decide whether they will lend you at all, and if they will, what interest rate to offer you, and whether or not they will require private mortgage insurance, or PMI. The LTV ratio also takes into account when homeowners plan to refinance their mortgage or refinance with a cash-out.

What is a good loan-to-value ratio?

In the eyes of lenders, a lower LTV is better than a higher LTV. Indeed, this ratio is an indication of the equity in your home, your ability to make mortgage payments and, relatedly, the lender’s ability to cover the balance of a mortgage if they have to foreclose on the home. and sell it. As a result, borrowers with a higher LTV are considered riskier for lenders.

Many lenders target 80% for what is considered a “good” loan-to-value ratio, and this ties into the long-standing rule of thumb of a 20% down payment. But just as there really isn’t a hard and fast rule for the amount of down payment required, you can still qualify for a loan with an LTV ratio above 80%. That said, your LTV ratio is likely to take into account the mortgage rates offered by lenders.

“Lower LTV ratios can lead to lower interest rates, but how much lower may depend on the type of loan you’re trying to qualify for, the price of the home, and factors like your personal credit score,” says Alec. Quaid, a Denver-based Certified Financial Planner with American Portfolios. Conversely, homebuyers and refinancers with LTV ratios above 80% may face higher borrowing costs or fees, he adds.

With automatic LTVs, the the same basic principles apply. However, since cars depreciate quickly, car LTVs above 100% are common. Credit bureau Experian recently reported the Average LTV was 117% for new cars and 114% for used cars.

Loan-to-value ratios and private mortgage insurance

If your LTV ratio is over 80%, you may need to make some changes to your home buying equation. Specifically, you may need to purchase private mortgage insurance if you are unable to increase your advance payment.

If you can’t get a 20% down payment, getting private mortgage insurance “isn’t the end of the world,” says Quaid. Typically, you can expect to pay 0.5% to 1% of your total loan amount per year on PMI, which means you’ll pay an additional $2,000 to $4,000 each year for this insurance on a $400,000 loan. And even if you can’t get a 20% down payment, the more money you deposit, the lower the amount of PMI you’ll have to pay.

It’s important to note that PMI protects lenders – not homebuyers – in the event that you stop making payments on your mortgage. Although the costs may be slightly higher, as long as you can afford the monthly payment, don’t let PMI stop you from buying a home, advises Quaid. Additionally, once you have at least a 20% equity interest in your home, you can ask your lender to cancel the PMI.

How to track home values ​​and how appraisals are determined

The LTV calculation is based on the appraised value of a home and, as recent years have demonstrated, there are times when there is a chasm between selling prices and appraisal values. If a house that sells for $400,000 is appraised for less, say $360,000, and you still have to borrow $320,000 to buy it, your LTV ratio jumps to almost 89%. Conversely, if an appraisal shows the house is worth more, say $440,000, your LTV drops to almost 73%.

As the housing market warmed in 2020 and 2021, a challenge for homebuyers and mortgage lenders was that sales prices exceeded estimated market values, Leon notes. There may still be a mismatch between sales prices and appraised values, and with the housing market entering “more difficult” times, he says, lenders need to carefully consider the risks associated with the mortgage approval for lenders who may be riskier for a write-off, such as those with a high LTV ratio.

You can get an idea of ​​a home’s value by tracking comparable sales in the area, but ultimately you’ll need an official appraisal, says Richard Martin, director of real estate solutions at research firm Curinos. . An appraisal is done by an independent appraiser who determines the fair market value of a home based on factors such as the living conditions of the home, home improvements, and the value of nearby homes. Assessments typically take one to two weeks and costs $300 to $450, but can cost much more for complicated properties. according to online real estate company Opendoor.

Existing homeowners have some ability to improve the assessment by making small improvements, tidying up, or addressing the “curb appeal” of your home. Buyers, on the other hand, don’t have much ability to influence the appraisal, but you can challenge a low appraisal value by presenting evidence of home improvements that the appraiser may have missed, d ‘errors in the report or comparable sales that are not relevant.

If you don’t like the result of the review and the dispute process yields no results, it may be time to re-evaluate your purchase decision. If your LTV ratio is over 80%, “it doesn’t necessarily preclude you from receiving funding,” says Martin. For most borrowers, this will mean buying PMI. However, some borrowers may be able to research programs, such as those offered by Fannie Mae and Freddie Macwhich allow down payments as low as 3% although these still require PMI.

Loan-to-value ratio and refinancing

LTV doesn’t just apply during the home buying process. For existing homeowners, this ratio shows how much you owe, or principal balance, on your mortgage, compared to the value of your home, and it will again be important when refinancing.

Certain factors work in favor of the owners. First, home values ​​generally appreciate over time, which helps lower your LTV ratio. Plus, as you pay down your mortgage and increase the equity in your home, it will also help reduce your mortgage. Therefore, you may be a more attractive borrower when refinancing.

When refinancing, lenders consider the principal balance of your mortgage against the value of your home, Martin notes. They, in turn, rely on the LTV ratio to determine how much you can withdraw and what interest rates you qualify for when refinancing. As with buying a new home, lenders generally want to see an LTV ratio of 80% or less with refinancing (including cash-in refinancing), although requirements may vary for second homes, other types of mortgages and the specific lender.

When refinancing, you want to get the highest possible appraisal value to increase your home’s equity – and that’s when some of these small improvements can potentially add up in a big way.

Any advice, recommendations, or rankings expressed in this article are those of the WSJ’s Buy Side Editorial Team, and have not been reviewed or endorsed by our business partners.