The Lower the Loan-to-Value Ratio, The Higher the Owner’s Equity – What You Need To Know

The loan-to-value (LTV) ratio is one of the most important factors lenders consider when approving a mortgage. It represents the ratio between the amount borrowed and the appraised value of the property. The lower the LTV ratio, the more equity the owner has in the property, which results in lower risk for the lender. In this article, we’ll take a deep dive into loan-to-value ratios, explain why a lower ratio is better, and provide tips for improving your ratio.

What is a Loan-to-Value Ratio?

The loan-to-value ratio compares the amount of the mortgage to the appraised value of the property. It is calculated by dividing the mortgage amount by the home’s appraised value. For example if you purchase a $200000 home with a $160,000 mortgage, the LTV ratio would be 80% ($160,000 / $200,000).

The lower the ratio the more equity the borrower has in the home. A lower LTV indicates the borrower has made a larger down payment which provides a cushion for the lender if the borrower defaults on the loan. On the other hand, a higher LTV means the borrower has less equity and is considered a higher risk for lenders.

Why is a Lower LTV Ratio Better?

There are several key reasons why a lower LTV ratio is preferable for borrowers:

• Lower interest rates – Lenders typically offer the lowest interest rates to borrowers with LTV ratios at or below 80%. As the ratio moves higher, interest rates tend to increase as well to account for the added risk.

• Avoid mortgage insurance – If your LTV is above 80%, most lenders will require you to pay for private mortgage insurance (PMI). This adds an expensive monthly premium to your payments. With a lower LTV, you can avoid this added cost.

• More likely to be approved – Lenders view borrowers with lower LTVs as lower risk. If your ratio is too high, you may have difficulty getting approved for a loan at all. A lower ratio boosts your chances.

• Build equity faster – The more equity you have upfront in the form of a down payment, the faster you will build toward the 20% threshold to eliminate PMI. Lower LTV borrowers build equity more quickly.

• Weather downturns – If the housing market declines, lower LTV borrowers are less likely to end up underwater on their mortgage since they have more equity built up as a cushion. Higher LTV borrowers have less room for error.

Tips for Improving Your LTV Ratio

If your LTV is on the high side, here are some tips for improving it before applying for a mortgage:

• Make a larger down payment – The most direct way to lower your LTV is to put more money down upfront. Saving for a down payment may allow you to significantly reduce your ratio.

• Avoid high-end homes – Opting for a more moderately priced home can help keep your mortgage amount lower relative to the value of the property. This prevents your ratio from getting inflated.

• Get a co-signer – Adding a co-signer with good credit may allow you to qualify for a lower rate, reducing your required mortgage amount. Just be sure the co-signer understands the obligation they are taking on.

• Improve your credit – Good credit means better mortgage rates and terms. Work on improving your score before applying to keep your mortgage costs as low as possible.

• Shop for better valuations – Get quotes from multiple appraisers and share details that may boost your home’s valuation, like recent renovations. A higher appraisal value lowers your ratio.

• Make extra payments – Making an extra principal payment or two before applying for a refinance can lower your loan balance relative to the home value, reducing your LTV.

• Wait to build equity – If your ratio is just a little high, waiting a few years while making payments can significantly bring down your LTV over time as you build equity.

The 80% LTV Benchmark

Most lenders use an 80% LTV ratio as a benchmark. Borrowers with ratios below this level are able to get the very best rates and avoid PMI. As you move above 80%, costs and qualifications start becoming less favorable. Once you surpass 95%, it can be very difficult to get approved at all.

It’s important to know the LTV requirements for the loan program you are using. Conventional loans generally follow the 80% guideline. But programs like FHA and VA loans allow for higher LTVs, up to 96.5%, in exchange for paying mortgage insurance.

As you shop for a mortgage, the lower you can get your ratio, the better. Work on boosting your down payment savings and improving your credit. And be prepared to show documentation that supports a strong home valuation. Taking these steps can put you in a position to land better rates and terms.

While coming up with a substantial down payment can be challenging, the benefits of lowering your LTV are significant. Aiming for at least 20% down is ideal. But any steps you can take to reduce your ratio will pay dividends over the life of your mortgage.

Frequently Asked Questions

What is considered a good LTV ratio?

A good LTV ratio is generally 80% or lower. This allows you to get the best mortgage rates and avoid private mortgage insurance. Anything below 80% is considered excellent, while ratios over 95% may make getting approved difficult.

How much down payment do I need for a 75% LTV?

To get a 75% LTV ratio, your down payment would need to be 25% of the home’s value. For example, on a $300,000 home, you would need to put down $75,000 to reach a 75% LTV. This upfront contribution provides a nice equity cushion.

What can I do to improve my LTV ratio?

The main ways to improve your LTV are making a larger down payment, choosing a lower priced home, getting a co-signer, increasing your credit score, obtaining a higher appraisal, and making extra payments before applying for a mortgage.

Does a higher or lower LTV mean less risk?

A lower LTV represents less risk for lenders because it means the borrower has more equity invested upfront. Higher LTVs indicate less equity and more risk. That’s why lenders offer better rates and terms to lower LTV borrowers.

How long does it take to reduce LTV?

Assuming a fixed-rate mortgage with consistent payments, your LTV will decrease by about 1% per year as you pay down the principal and build equity. Significant prepayments or home appreciation can lower it faster. Generally it takes 7-10 years to go from a 90% to 80% LTV.

Aiming for the lowest possible loan-to-value ratio when getting a mortgage should be your goal. The more equity you have, the lower the risk for lenders and the better the rates and terms they can offer you. Evaluate your options for boosting your down payment and limiting the amount you need to borrow. This can set you up for mortgage success by reducing costs and giving you a buffer against housing declines. While coming up with a large down payment can be challenging, the long term benefits of a low LTV make it well worth the effort.