LTV Ratio and Mortgage Payments

Several factors go into determining your mortgage rate when you buy a home. Lenders will consider your credit history, employment history, savings and assets, income, and debt-to-income (DTI) ratio. Another important factor is your loan-to-value (LTV) ratio.

What Is a Loan-to-Value (LTV) Ratio?

When you’re buying a home, the loan-to-value (LTV) ratio compares the amount of your mortgage to the home’s purchase price, expressed as a percentage. The smaller your down payment, and the more you borrow, the higher your LTV ratio will be.

In the case of a home that you have owned for a while, the LTV ratio will compare your current mortgage balance to the home’s current appraised value.

LTV Ratio Formula

The formula for an LTV ratio is simply the amount of your loan divided by the value of the asset—in this case, a home.

Calculating the LTV Ratio

Calculating your LTV ratio is easy.

For example, say you’re looking for a new home. You have your eye on a $300,000 house and can afford to put 10% down, or $30,000. The mortgage would be $270,000, resulting in an LTV ratio of 90%. That’s $270,000 ÷ $300,000.

Another way to arrive at the same result is simply subtracting the percentage rate of your down payment from 100%. In the example above, your LTV ratio would be 100% - 10%, or 90%.

A lower LTV ratio is preferable for a number of reasons. Most important, from a financial perspective, mortgage lenders typically provide better terms when LTV ratios are no higher than 80% (meaning a down payment of 20%). What’s more, putting more money down increases your equity in the home, which can be handy if you ever want to refinance your home or borrow against it by taking out a home equity loan.

How to Lower Your LTV Ratio

If you’re buying a home, you can lower your LTV ratio by making as large a down payment as you can reasonably afford. (Bear in mind that you could also face substantial closing costs.)

If you already own a home, then you have a number of options for lowering your LTV ratio. For starters, each monthly mortgage payment that you make will lower it a little, as your loan balance gradually shrinks. At the same time, if your home is appreciating in value, as is often the case, that will also reduce your LTV ratio.

A more aggressive approach to lowering your LTV ratio is to make additional principal payments each month or whenever you have the cash to spare. That will not only reduce your LTV ratio but also allow you to pay off your mortgage sooner and less expensively in terms of total interest. This approach is often referred to as accelerated payments.

How LTV Ratio Affects Mortgage Payments

While a 20% down payment may be ideal from a lender’s point of view, programs are available to help homebuyers who can’t scrape up that much cash. For example, the Federal Housing Administration (FHA) backs loans made by FHA-approved private lenders to borrowers who put down as little as 3.5%. (To be approved for a 3.5% down payment, the borrower must have a FICO score of at least 580. Borrowers with a score from 500 to 579 need to put at least 10% down, and those with scores under 500 are not eligible for the program.)

The U.S. Department of Veterans Affairs (VA) backs 0% down mortgages for eligible veterans of the armed forces, provided that the home’s sale price is no higher than its appraised value.

However, there are drawbacks to taking a mortgage with a high LTV ratio. For starters, the monthly payment will be higher. This is due to both the higher principal payments and the higher interest rate that a lender is likely to charge, based on the perception that a higher LTV ratio equates with a greater risk of the borrower defaulting on the loan.

In addition, borrowers with high LTV ratios are often required to purchase private mortgage insurance (PMI) and to continue paying for it until the equity in their home reaches 20%.

PMI is calculated each year as a percentage of the original loan amount. It ranges from 0.25% to 2% of the loan (depending on the LTV ratio and your credit score) and is added to the monthly mortgage payment. PMI costs can be substantial over time. Under the Homeowners Protection Act of 1998, borrowers can cancel their PMI coverage after achieving 20% home equity, and lenders are automatically required to cancel it once equity hits 22%.