Why does the loan-to-value ratio matter?
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 home being purchased. For example, a transaction that includes a home with a purchase price of $200,000, a down payment of $10,000 and total mortgage balance of $190,000 results in an LTV ratio of 95%.
Lenders perceive a lower LTV ratio to be a better long-term risk equating to a higher equity ownership stake in the home. An LTV ratio that is greater than 80% is considered a higher-risk transaction, and borrowers often pay more over the life of the mortgage loan when the ratio is in this range. This calculation is used in new purchases and refinance mortgage transactions.
Loan to Value Ratio and Interest Rates
The amount of equity a borrower has in the home drastically affects the interest rate assessed on the remaining loan balance in both refinance and new purchase transactions. When a homeowner wants to refinance a mortgage loan, it is common to affect this transaction with the intent to lower the total interest rate, reducing total monthly costs. However, if a homeowner taps into the equity of his home in a cash-out refinance, lenders are often unable to provide the owner with the lowest prevailing interest rates on a new mortgage loan. Additional risk is taken on by the lender, and a higher interest rate reduces that risk.
Similar interest rate increases are assessed in home purchase transactions. An LTV ratio of greater than 80% may disqualify a borrower from the lowest interest rate offered by a conventional lender, and it may require taking out an alternative mortgage through a different lender or through a government program. For instance, the Federal Housing Administration loan program offers home buyers the opportunity to put down as little as 3.5%, creating an LTV ratio of 96.5%. Interest rates on low down payment loans are higher than those assessed on mortgage transactions with higher down payment amounts.
Loan to Value Ratio and Mortgage Insurance
Borrowers who cannot contribute a down payment of at least 20% are not disqualified from obtaining a mortgage loan, but they are considered high-risk debtors by mortgage lenders. To provide lenders peace of mind in these cases, 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 meant to pay off the balance of the mortgage loan if the borrower stops making payments.
Borrowers can expect to pay between 0.25% and 2% of the total mortgage balance each year that private mortgage insurance is required. This premium is often lower for borrowers who provide a down payment closer to the traditional 20% or those who have a high credit score. When the LTV ratio decreases with on-time payment and increases in home value, borrowers can request that PMI be canceled once 20% equity is reached. The law requires that lenders automatically cancel a borrower's private mortgage insurance when the LTV ratio reaches 22%.