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What is a Loan-to-Value Ratio?
The loan-to-value ratio, or LTV ratio, refers to an assessment of lending risk by financial institutions and other lenders. They evaluate each loan applicant’s LTV ratio to determine whether they will approve several types of loans, including but not limited to mortgages, automobile loans, and refinances.
The higher the loan-to-value ratio, the higher the risk of default. If the lending institution decides to approve a mortgage with a high LTV ratio, the interest rate will also be high to reflect the risk involved. Some borrowers receive approval only if they consent to purchasing private mortgage insurance (PMI) to mitigate the risk to the lender.
LTVs are part of a bigger picture that includes:
- Your credit score
- Your income available to make monthly payments
- The condition and quality of the asset you’re buying
DID YOU KNOW?
Typically, applicants who have a loan-to-value ratio at or below 80% will receive the lowest possible interest rates on their mortgages and/or home equity.
In this article, the Zero Theft Movement will cover the loan-to-value ratio and what you can do to pay as little interest as possible on your loans. We will also look at how LTV ratios went ignored in the leadup to the subprime mortgage crisis.
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Calculating a Loan-to-Value Ratio
The equation to determine your LTV ratio is:
LTV ratio = (Amount owed on the loan ÷ Appraised value of asset) x 100
Let’s plug in some random numbers to show you an example calculation. Person X wants to purchase a home with a fair market value of $500,000. X has $100,000 available for a down payment. Therefore, they need to borrow $400,000 more to reach that $500,000 value.
($400,000 ÷ $500,000) x 100 = 80%
Person X’s loan-to-value ratio is 80%. That means they would likely be able to receive the lowest possible interest rate on their mortgage. But if there was an increase in fair market value, then the loan-to-value ratio would increase. On the flip side, if person X can afford a bigger down payment, the LTV ratio would decrease.
If you don’t want to crunch the numbers yourself or have a multi-mortgage case, you can find many LTV ratio calculators online to do the heavy lifting for you.
How the LTV Ratio is Used by Lenders
The LTV ratio serves a key role in mortgage underwriting. Whether an applicant wishes to purchase a home, refinance their current mortgage into a new loan, or borrow against accumulated equity with a property, lenders use the applicant’s loan-to-value ratio to (1) help decide your eligibility and (2) determine how much interest you will have to pay.
As a general rule of thumb, the lower the applicant’s LTV ratio, the higher their chance of getting their loan approved. Other factors, such as your credit score and income, will also influence the lender’s decision. For example, if you have received a major promotion that has raised your salary dramatically, the lender might be more inclined to approve your loan despite your initial down payment.
Applicants who have a loan-to-value ratio over 80% will pay a sub-optimal interest rate and sometimes even purchase PMI (0.5% to 1% added to the total amount of the loan annually). Some lenders will not even approve a loan if an applicant’s LTV ratio exceeds 80%.
To give you an idea of how much extra costs this could incur, a PMI with a rate of 1% on a $400,000 loan would add an additional $4,000 to the total amount paid per year. PMI payments will typically be required until the LTV ratio drops to 80% or below. As long as you consistently make your payments, the LTV ratio will decrease as you chip away at your loan and the value of your home increases over time.
While it is not a law that lenders require an 80% LTV ratio in order for borrowers to avoid the additional cost of PMI, it is the practice of nearly all lenders. Exceptions to this requirement are sometimes made for borrowers who have a high income, lower debt, or have a large investment portfolio.
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Loan-to-Value Ratios in the 2008 Subprime Mortgage Crisis
The explosion of NINJA loans (“No income, no job, no asset” loans) had much to do with the U.S. real estate boom of the mid-2000s. This form of subprime lending, now virtually extinct, essentially allowed borrowers to acquire major loans without showing proof of their income, job, or assets. Loan-to-value ratios went out the door as lenders operated under the assumption that home values would continue to rise.
Source: Economics Help
Many took advantage of these loans, purchasing the property they would have never been able to prior. Due to the glaring lack of a verification process, these loans came with high interest rates. The problem was, those high rates did not kick in until the initial period at a low ‘teaser’ rate had ended. Borrowers defaulted on their loans and disappeared (hence, the ninja moniker) when they had to start paying those high rates.
According to the UC Berkeley-backed Institute for Research on Labor and Employment, “Banks gave risky loans, such as ‘NINJA’ loans…to individuals who could not afford them, knowing that the loans were likely to default. Banks that created mortgage-backed securities often misrepresented the quality of loans. For example, a 2013 suit by the Justice Department and the U.S. Securities and Exchange Commission found that 40 percent of the underlying mortgages originated and packaged into a security by Bank of America did not meet the bank’s own underwriting standards.”
These NINJA loans, packaged and presented in high-quality collateralized debt obligations (CDOs), tanked. Investment giants Bear Stearns and Lehman Brothers had invested a great deal in these securities and consequently collapsed. Insurance companies had also profited greatly by selling credit default swaps, protections against defaults on CDOs. The global economy went into a long recession, derailing millions of retirements and budding careers.
Lowering your Loan-to-Value Ratio
Lowering your loan-to-value ratio often means a lower total cost for you. You can save money in two ways: making a larger down payment and/or purchasing a more affordable home. That way you can avoid high interest rates and potential insurance costs.
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