The average homeowner saw an increase of $15,000 in the equity — or ownership value — of their property in 2017, according to real estate industry data company CoreLogic.
That’s a good chunk of change. If you own a home or plan to buy one, that sort of increase in household wealth probably is a big reason you’re interested in making such a large purchase, even if you need debt to do it.
Figuring out how much wealth is in your home has a lot to do with what’s known as your loan-to-value (LTV) ratio.
“The loan-to-value ratio is often overlooked once people get past a minimum down payment,” said Todd Huettner, the president of residential real estate mortgage lender Huettner Capital. “However, it can save a lot of people a lot of money if they truly understand how it works.”
Here’s what you need to know about the LTV ratio.
What loan-to-value ratio means
At its most basic, the LTV ratio describes the relationship between the amount you owe on your mortgage and your home value.
An appraisal usually is required to determine the home’s market value, according to David Hosterman, a mortgage professional and branch manager with Castle & Cooke Mortgage. “To find the loan-to-value ratio, you divide how much you owe on the home by its appraised value,” he said. “The resulting percentage is your LTV.”
For example, if you buy a home worth $200,000 using a 10% down payment, you’ll end up borrowing $180,000 so your LTV is 90%.
The formula for how your LTV is determined on a home purchase comes with little tweaks, though, said Huettner.
“It’s going to be the lower of the purchase price or the appraised value,” he said. “A loan of $70,000 on a house with a purchase price of $100,000 that appraises for $110,000 would still only have an LTV of 70%.”
Your LTV changes over time. As you make mortgage payments, you build equity in your home, reducing your LTV. Plus, if home values in your real estate market rise, your LTV ratio will change.
And if you borrow against your home or if you get a cash-out refinance, your LTV will rise again because your mortgage debt will be higher. Then if the housing market drops, you also could see a higher LTV with the reduction in your home value.
Whenever you refinance your mortgage or get a home equity loan, the lender calculates your loan-to-value ratio again, based on your new mortgage balance and the updated appraisal of your home.
How your loan-to-value ratio influences the mortgage process
There are a few ways LTV can impact how your mortgage (including a refinance) is handled. Here are some things to keep in mind:
“Loan programs have a maximum LTV they allow,” said Huettner. “With a home purchase, this sets your down payment.”
Here are some examples provided by experts:
- If a program has an LTV limit of 95%, you need a down payment of 5% to meet the requirements.
- If you get a Federal Housing Administration (FHA) loan, you need a 3.5% down payment, so the LTV is 96.5%.
- Some government-backed loans — such the ones from the U.S. Department of Agriculture and the Department of Veterans Affairs — allow for 100% LTV, with no down payment required.
- For years, though, the rule of thumb has been 80% LTV, which results in the standard 20% down payment.
- The average down payment for a mortgage in 2016 was 11%, according to the National Association of Realtors (NAR). So, the average LTV for many homebuyers was 89%.
When refinancing your mortgage, the LTV matters to some degree. After all, you might not be able to refinance if your home value has dropped to below what you owe on the home, according to Hosterman.
With a cash-out refinance, though, your loan-to-value ratio is extremely important. In such a cash-out transaction, you receive a portion of your equity in cash when you go through the process of refinancing. As a result, a low LTV is important.
“An FHA cash-out refinance has a limit of 95% loan-to-value,” said Hosterman. “Fannie Mae allows for an 80% loan-to-value.”
In these cases, your total LTV after the refinance must be within those limits, and some lenders might have stricter requirements.
Say you owe $130,000 on your home. It’s appraised at $200,000 and you want a cash-out refinance. The new loan has to be at least $130,000 to replace your current mortgage balance.
However, you can’t take out the remaining equity of $70,000 in cash after that. Instead, you can borrow only up to the LTV limit set by your lender. If your lender’s limit is 80%, your total loan can amount only to $160,000. So, you can’t cash out more than $30,000.
Home equity loan or line of credit
There are LTV limits when you get any kind of home equity loan or line of credit as well. However, the limits might be higher, ranging from 85% to even 100%, depending on the lender and the program.
You might have $40,000 equity in your home, but you might not be able to borrow against that entire amount, according to Hosterman and Huettner.
Although there are some exceptions, you’re more likely to face limits again in the amount you’re allowed to borrow. If your home is worth $200,000 and the LTV cap is 85%, your total home-related debt (first mortgage plus equity loans or lines of credit) is limited to $170,000.
Perhaps you still owe $160,000 on the mortgage. It would be helpful to access that $40,000 equity as a home equity line of credit to remodel your home. Using the example above, you can borrow only up to $170,000. Instead of being able to access all the equity in your home, you can get a line of credit of up to $10,000 only.
Lower interest rate
“Loan-to-value ratio along with credit scores have an impact on the interest rate a borrower is likely to get,” said Hosterman. “If a consumer has a low LTV, they will likely get a lower interest rate.”
Huettner also pointed to LTV as an important factor when considering the long-term interest costs of a loan. He suggested that a lower LTV could mean big savings on your mortgage rate. Not only are you borrowing less, but you could also end up getting a discount of as much as 1% on your rate, all other factors being equal.
Using our mortgage calculator, you can compare the difference between a 5% down payment (95% LTV) and a 40% down payment (60% LTV), which Heuttner and Hosterman say will get you the best possible interest rate, as long as you also have good credit.
For example, this scenario shows the total amount you’d pay over the life on a 30-year mortgage of $200,000 if you put 5% down.
In this second scenario with the same $200,000 mortgage for a 30-year term, putting a down payment of 40%, instead, could lower the interest rate, which would trim the total amount you’d pay for the property.
So over a 30-year period, a bigger down payment coupled with a lower interest rate can lead to a savings of more than $150,000. That’s almost enough to buy another house!
However, not everyone can come up with a 40% down payment. It’s far more common for people to afford an 11% down payment, according to the NAR data.
However, even coming up with an additional 5% in the first scenario and getting that LTV down to 90% with a 10% down payment can make a big difference. Putting down $20,000 instead of $10,000 and getting an interest rate of 4.15% can lead to a savings of more than $33,000.
Private mortgage insurance
Another way LTV can impact your cost has to do with private mortgage insurance (PMI). You could end up paying for this insurance coverage if you have a loan-to-value ratio of more than 80%.
“PMI is a fee that can be the equivalent of having an interest rate that is higher by between 0.50% and 1.50%,” said Huettner. “That’s why a lot of people want to put down at least 20% when they buy a home.”
Paying PMI can be worth it in some circumstances. If you’re very interested in getting into a home and building equity, you might be willing to pay the PMI premium that comes with a smaller down payment.
Loan-to-value ratio: The bottom line
In general, you might assume that a lower LTV is better than a high LTV. And when it comes to the cost of your loan only, that might be true.
However, Huettner doesn’t think the mortgage or refinancing process should be only about costs. Instead, you should consider all your options and think about your long-term homeownership goals. Your plans and priorities can make a difference.
Understanding LTV, though, can be a big help as you move forward. Once you know how it impacts your situation, you can make more informed decisions.
“There’s not really a good LTV ratio,” Huettner said. “It’s really about the LTV that lets you do what you’re trying to do from a lending perspective.”