There’s a reason that lenders often reemphasize one common phrase throughout the homebuying process: it’s one of the most expensive purchases you’ll ever make.

With that purchase comes risk, as real estate transactions are often established through financing that runs 30 years or more. The reality is, that financing is established on properties that can — and often do — transact at prices well above their collateral values.

What does that mean for the homebuyer? It means you need to understand the way loan-to-value (LTV) ratios work so that your home isn’t “under water” at origination. In other words, don’t sign on the dotted line until you have a firm grasp of LTVs and the underwriting process that will take your mortgage loan to the finish line.

LTV: The risk control practice for your mortgage

If you’re looking for a better understanding of loan-to-value ratios, it can be broken down into a very simple formula.  Divide your anticipated mortgage amount (the full amount you’ll borrow at closing) by the appraised property value of the home you wish to purchase. For example, if you buy a home appraised at $200,000, and make a $15,000 down payment, you will borrow approximately $185,000. This results in an LTV ratio of 92.5% (or 185,000/200,000).

Every type of mortgage — conventional home loans, FHA, USDA, and even jumbo mortgages — are affected by LTVs. When mortgage lenders tighten lending standards (as they have done more recently during the coronavirus crisis), it’s even more important to be aware of. In fact, Forbes says that other common changes to borrower requirements include raising the minimum FICO scores needed for loan approval, bolstering income documentation protocols, and lowering LTV minimums.

Everything above is part of the overall risk control practice of lenders approving a mortgage. The LTV ratio ultimately determines the level of risk they’re taking on. Why? When borrowers apply for a loan amount at or near the appraised value, lenders know there’s a greater chance the loan may later go into default.

What Goes Into Your LTV (And Why It Matters)

While we listed a very basic formula above, there’s more that goes into your loan-to-value ratio than two overall numbers. The main factors that will impact that ratio need to be looked at more clearly. They are:

  • the amount of your down payment
  • the sales price of the property
  • the appraised value of the property

Factoring all of this together, you’ll lower your LTV ratio by making a higher down payment and locking in your home at the lowest possible sales price.

You should know that the LTV ratio, while important, is also just one factor determining your ability to get a mortgage. However, it will likely play a big role in the interest rate you’re able to secure.

Currently, most lenders offer the best possible interest rates to borrowers when the LTV is at or below 80%. While a higher LTV on your mortgage won’t prevent you from being approved for a mortgage, the interest rate on the loan will undoubtedly increase. That affects the amount you’ll pay over the life of the loan in a big way.

You should also remember that when the property appraises for more than the purchase price, the LTV is based on that purchase price rather than the appraisal. 

Different Loan Types, Different LTV Requirements

Different loans are going to have different rules when it comes to your LTV requirements. We mentioned things like FHA and USDA loans (which will be examined here in detail) but LTV also affects VA loans, Fannie Mae and Freddie Mac mortgage programs, and mortgage refinancing.

FHA Loans

FHA loans are insured by the Federal Housing Administration and issued by FHA-approved lenders. They are one of the most common mortgage products used, especially by first-time buyers.

While FHA loans are heralded for requiring just a small minimum down payment (3.5%) and credit scores lower than conventional loans, there’s one big drawback.  Because FHA loans allow an LTV ratio of up to 96.5%, they’ll require the borrower to pay a mortgage insurance premium that lasts for the life of the loan.

VA and USDA Loans

There are different VA loan programs designed to help buy, build, or improve a home or refinance. Most commonly, VA loans are used to buy a property and a VA-backed purchase loan requires no down payment (as long as the sales price isn’t higher than the property’s appraised value). That means the LTV can be up to 100% and there is no mortgage insurance required.

VA loans are only for eligible veterans, current service members, and survivors with full entitlement (such as a spouse who has not remarried). 

On the other hand, those members of the general public looking for a guaranteed loan program with strong benefits should consider a USDA guaranteed loan.

While eligibility is dependent upon a number of factors, the LTV is on par with a VA loan. That means it’s possible for the loan-to-value to not only reach 100% but to go as high as 100.35% due to a guarantee fee attached to the loan. (USDA loans may exceed the full LTV only to the extent that it also includes that guarantee fee of 0.35%).

Fannie Mae and Freddie Mac

Both the HomeReady program from Fannie Mae and the Home Possible program from Freddie Mac are geared towards low-income borrowers. Consequently, they allow an LTV of up to 97% of the loan. However, mortgage insurance is required until there’s at least 20% equity built up in the property.

What is CLTV?

Anyone looking to alter their existing loan should understand CLTV, or what’s known as the Combined Loan to Value Ratio. This is a borrower’s overall combined mortgage debt, which factors in second mortgages, home equity loans, lines of credit, and any other liens.

The combined CLTV is found by adding the total of both loans together and then dividing the appraised value. For example, if you have a home worth $300,000, let’s assume the buyer took out a primary mortgage of at least $280,000 but the principal on the home is now $150,000. If the buyer later took out a home equity loan for $50,000, the combined CLTV ratio would be calculated:

  • Primary mortgage debt ($150,000) + home equity loan ($50,000) = $200,000
  • Total mortgage debt = $200,000 / appraised value ($300,000) = 0.66 or 66 percent CLTV

Lenders will use a CLTV ratio to calculate a potential risk of default when a borrower has more than one loan. According to Bankrate, it is considered a more inclusive measure of a borrower’s ability to repay the loans.

The Bottom Line

Remember, your loan-to-value ratio all goes back to risk. This inevitably leads to borrowers with poor credit being charged more than borrowers with good credit and applies to your LTV in kind. A high LTV ratio means more risk to the lender, and that translates to higher interest rates on the loan.

If you’re locking in a mortgage with a conventional loan, an LTV ratio greater than 80% will likely require PMI, covering the lender if you fail to repay the loan.

Overall, it’s imperative you understand how the LTV ratio affects your overall borrowing costs, and how decreasing your LTV can help you save over the life of the loan.