Loan to Value Ratio - Explained
What is the Loan to Value Ratio?
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Table of ContentsWhat is the Loan-To-Value Ratio?How Does the Loan to Value Ratio Work?
What is the Loan-To-Value Ratio?
The Loan-to-value (LTV) ratio is the ratio of the mortgage amount and the total appraised value of the property. The financial institutions and other lenders calculate this to measure the mortgage risk before approving a mortgage loan. A high loan-to-value ratio indicates a higher risk of default. The lenders approve loans with higher loan to value ratio against a high rate of interest and the debtor may also have to purchase additional mortgage insurance in order to balance the risk.The Loan-to-value ratio is calculated as
Loan to value ratio= Mortgage Amount / Appraised Property Value
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How Does the Loan to Value Ratio Work?
The loan-to-value ratio is an important component of mortgage underwriting. It helps the lender to estimate the level of the risk they are being exposed to by approving the loan.For example, Joe Williams decides to purchase a real estate property with $800,000. She puts $ 120,000 down and plans to borrow the rest. So, her loan to value ratio would be calculated as($800,000-$120,000)/$800,000= 85%.If a borrowers LTV crosses 100%, they are considered to be upside down on their mortgages. They owe more on the house than the house is worth, and no equity is built up within the property. These borrowers are more likely to default on the loan and on the occasion of a foreclosure, the lender may find it difficult to sell the property in a price that covers up the outstanding mortgage amount. Generally, the lending agencies prefer an LTV ratio which is lower than 80% and provides better loan term to them. The lender may require the borrower to buy private mortgage insurance if the loan to value ratio of a mortgage loan is higher than that.The FHA lenders may allow up to 96.5% loan to value ratio while approving a mortgage, but it requires the borrower to pay a mortgage insurance premium as long as the total loan amount is not repaid. It doesn't matter how the loan to value ratio goes down eventually. So, the borrowers are most likely to refinance their loan to a conventional one, one the loan to value ratio reaches 80%.The VA loans available to the present and former military personnel and the USDA loans available to the rural population may allow a 100% loan to value ratio. As these loans are fully or partially guaranteed by the government, no additional mortgage insurance is required.As can be seen in the above calculation, the loan value depends on three factors the sales price of the property, the down payment, and the appraised value. The loan to value ratio can be improved by increasing the down payment or by negotiating a lower sales price. A lower loan to value ratio ensures the approval of the loan without the support of private mortgage insurance, in a lower interest rate.