Maximum Loan-To-Value Ratio

What Is a Maximum Loan-To-Value Ratio?

A maximum loan-to-value ratio is the largest allowable ratio of a loan's size to the dollar value of the property. The higher the loan-to-value ratio, the bigger the portion of the purchase price of a home is financed. Since the home is collateral for the loan, the loan-to-value ratio is a measure of risk used by lenders. Different loan programs are viewed to have different risk factors, and therefore, have different maximum loan-to-value ratios.

Key Takeaways

  • A maximum loan-to-value ratio is the largest allowable ratio a bank allows when comparing the size of a loan to the purchase price of a property.
  • The higher a loan-to-value ratio is, the higher the portion of a property's purchase price is financed.
  • The loan-to-value ratio is a measure of risk used by lenders when deciding how large of a loan to approve.
  • For a home mortgage, the maximum loan-to-value ratio is typically 80%.
  • Higher loan-to-value ratios may require a borrower to purchase insurance to protect the lender or result in higher interest rates.

Loan-to-Value Ratio

Understanding a Maximum Loan-To-Value Ratio

A maximum loan-to-value ratio will be different for every type of business and every type of asset. When determining a maximum loan-to-value ratio, a lender wants to ensure that it can recoup any losses if the borrower defaults and it has to sell the asset to cover the unpaid portion of the loan. The lower the maximum loan-to-value ratio is, the less risk the lender is taking on because they are putting up less money. Maximum loan-to-value ratios are often used in home loans and auto loans.

Some home loan programs allow for a high maximum loan-to-value ratio and are designed specifically for low- to moderate-income and first-time home buyers. Many of these programs are sponsored by state and local governments, the Federal Housing Administration (FHA), and the Veterans Administration. It is wise for a borrower to investigate these options before selecting any one lender's high loan-to-value program.

The combination of a mortgage loan along with a down payment is used to buy a home for most home buyers. The property serves as collateral for the loan and so in the event the purchaser can no longer make the loan payments, the lender takes possession of the property. The lender can then sell the property and use the proceeds to repay themselves in the amount of the borrowed money. In the loan approval process, the lender places a maximum allowable amount on the loan versus the property value because if the loan is too big a portion of the property value, the bank may not be able to get the entire value back in the event of a borrower default.

Determining a Good Maximum Loan-To-Value Ratio

Calculating a loan-to-value ratio is straightforward. You divide the amount of the loan by the purchase price of the asset. Determining the maximum loan-to-value ratio is an exercise lenders decide upon based on a number of factors, such as the borrower's credit profile and the ability to sell the asset to recoup the loan amount in case of a default.

Every asset will have a different maximum loan-to-value ratio. For homes in the U.S., it is standard for a home buyer to make a down payment of 20%, meaning that they will have to borrow 80%. For example, if a home costs $200,000, and the home buyer can make a downpayment of 20%, they put in $40,000 of their own money, and the remainder, $160,000, is borrowed through a lender in the form of a mortgage. In this case, the loan-to-value ratio is 0.80 (160,000 / 200,000), or 80%. This is usually considered the maximum loan-to-value ratio for a mortgage. The less the bank needs to lend means that if the borrower defaults, there is a higher likelihood it will be able to sell the asset for a price that will cover the loan.

If you ask for a higher loan amount for a mortgage, you may need to get private mortgage insurance (PMI) to protect the lender, which is an added cost. Or you may have a higher interest rate on your loan, also increasing the cost. If a mortgage is obtained through the Federal Housing Administration (FHA), the maximum loan-to-value ratio is typically 97%.