For mortgage lenders and borrowers, the loan-to-value ratio is an important factor in determining the repayment terms of a mortgage loan. The LTV ratio is calculated by dividing the total balance of the mortgage taken out by the borrower by the total purchase price or appraisal value of the property being purchased. For example, a transaction with a house with a purchase price of $ 200,000, a down payment of $ 10,000 and a total mortgage debt of $ 190,000 results in an LTV ratio of 95%.
Lenders see a lower LTV ratio as a better long-term risk, which corresponds to a higher participation in equity in the household. An LTV ratio that is higher than 80% is considered a higher risk transaction and borrowers often pay more during the term of the mortgage loan when the ratio is within this range. This calculation is used for new purchases and to refinance mortgage transactions.
Loan to value ratio and interest rates
The amount of equity that a borrower has at home has a drastic influence on the interest rate that is assessed on the remaining balance of the loan in both refinancing and new purchase transactions. When a homeowner wants to refinance a mortgage loan, it is common to influence this transaction with the intention of reducing the total interest rate, thereby reducing the total monthly costs. However, if a homeowner uses the equity of his home in a cash-out refinancing, lenders are often unable to give the owner the lowest interest rate for a new mortgage loan. Additional risk is taken over by the lender and higher interest rates reduce that risk.
Comparable interest rate increases are assessed for transactions with own purchases. An LTV ratio of more than 80% can disqualify a borrower from the lowest interest rate offered by a conventional lender, and may require an alternative mortgage to be taken out through another lender or through a government program. The Federal Housing Administration’s loan program, for example, offers home buyers the opportunity to reduce as little as 3.5%, creating an LTV ratio of 96.5%. The interest on loans with a low down payment percentage is higher than on mortgage transactions with higher down payment amounts.
Loan-to-value ratio and mortgage insurance
Borrowers who cannot make a down payment of at least 20% are not disqualified for obtaining a mortgage, but are considered risky debtors by mortgage lenders. To offer lenders peace of mind in these cases, a private mortgage insurance or a mortgage insurance premium is added to the monthly mortgage. This insurance coverage benefits the lender, not the borrower, and is intended to pay off the balance of the mortgage loan if the borrower stops making payments.
Borrowers can expect that between 25% and 2% of the total mortgage balance must be paid each year for taking out a private mortgage insurance policy. This premium is often lower for borrowers who give a down payment that is closer to the traditional 20% or to those with a high credit rating. When the LTV ratio decreases with timely payment and increases in the value of the home, borrowers can request to cancel PMI once the equity of 20% has been reached. The law requires lenders to automatically cancel a borrower’s private mortgage insurance when the LTV ratio reaches 22%.