Maximum Loan-to-Value Ratio: Definition, Formula, Examples

What Is a Maximum Loan-to-Value Ratio?

A loan-to-value ratio (LTV) compares the amount of a loan to the value of the property it is being used to purchase. A maximum loan-to-value ratio is the highest LTV a lender is willing to accept. In mortgage lending, for example, the higher the loan-to-value ratio, the larger the percentage of a home's purchase price that is being financed through borrowing. Since the home serves as collateral for the loan, lenders use the loan-to-value ratio as a measure of the risk they are taking on.

How Maximum Loan-to-Value Ratio Works

Lenders set maximum loan-to-value ratios to ensure that they can get their money back (or at least a good chunk of it) if the borrower defaults on the loan and the lender has to seize and sell their collateral. The lower the loan-to-value ratio is, the less risk the lender is assuming. Maximum loan-to-value ratios are used with many types of loans, particularly with home mortgages and auto loans.

Some home loan programs that are designed specifically for low- to moderate-income and first-time home buyers allow for relatively high maximum loan-to-value ratios. Many of these loans, which are offered through private lenders, such as banks, are sponsored and subsidized by state and local governments, the Federal Housing Administration (FHA), and the Veterans Administration, among others. Their guarantees reduce the lender's financial risk.

The maximum loan-to-value ratio a lender will accept can also vary from borrower to borrower. Lenders make that decision based on a number of factors, such as the borrower's credit profile and how easy it would be to sell their collateral in the event of a default.

Calculating Maximum Loan-to-Value Ratio

Lenders rarely offer loans that will cover 100% of the purchase price of a home or other asset. Instead, the borrower is required to make a cash down payment. In the case of some government-subsidized mortgages, that can be as low as 3%. (Two exceptions are VA loans and USDA loans, which are partially subsidized by the Veterans Administration and U.S. Department of Agriculture, respectively; they allow down payments as low as 0% in certain cases.) Other lenders require higher down payments, such as 10%, 15%, or 20%. A 20% down payment was once the common standard.

Calculating a loan-to-value ratio is straightforward. You divide the amount of the loan by the purchase price of the asset.

Suppose, for example, that you want to buy a $200,000 home and are planning to make a down payment of 20%, or $40,000. That means you'll need to borrow the remaining $160,000. In this case, the loan-to-value ratio would be 0.80 ($160,000 divided by $200,000), or 80%.

On the other hand, if you were able to buy that same home with a 3% down payment, such as through a Fannie Mae loan, your down payment would be $6,000, and your mortgage would cover the remaining $194,000. Here your loan-to-value ratio would be 0.97 ($194,000 divided by $200,000), or 97%.

Notably, if you make a down payment of less than 20% on a conventional mortgage, the lender will probably require you to purchase private mortgage insurance, or PMI. The purpose of PMI is to give the lender additional protection in the event of a default. If the equity you have in your home rises to a point where it equals or exceeds 20% of the original purchase price, you can ask the lender to cancel the PMI.

The cost of PMI varies according to the loan-to-value ratio of the mortgage, the creditworthiness of the borrower, and other factors. It can also vary from one insurer to another even under identical circumstances. As a general rule, the Federal Home Loan Mortgage Corporation (Freddie Mac) says that, "You can expect to pay between $30 and $150 per month for every $100,000 you borrow."

FHA and USDA loans can also have mortgage insurance requirements.

The Bottom Line

The maximum loan-to-value ratio on a mortgage can vary widely from lender to lender and program to program. If you're shopping for a mortgage it's smart to compare loans based on how large a down payment you can afford, what their interest rates and fees will mean in terms of your monthly payments, and whether you'll have the additional cost of PMI.