This is not the first article on the importance of using financial ratios. What’s more, their proper use is key to making wise financial decisions regardless of the goal. In this article, I will be looking at the loan to value ratio (LTV) and the importance of this measure when deciding on a mortgage offer.
Most people think that when applying for a mortgage, their lenders will consider only their current income, credit score, and history. That is not entirely true. All banks upon determining whether to give a loan or not also consider the LTV ratio. But what is it? Why is it so important? Do you need a high or low LTV?
What is Loan To Value Ratio?
Simply put, this ratio measures how much of the chosen property’s value is actually mortgaged. In other words, it compares the amount of the loan to the value of the property.
Lenders will use this measure to complement their decision whether to give a loan to a borrower or not. Usually, people need an 80% LTV to qualify, but occasionally it could be lower. For example, for investment purposes, banks require a lower LTV ratio (60%).
Why do banks need it?
Well, in our case a bank is an investor: they invest their money and expect interest payments in return. The LTV is part of their risk assessment and helps them mitigate risks when lending money. The higher the ratio, the riskier the investment.
How Does It work
The LTV shows the amount of money a lender is willing to give for a particular property. Of course, it is expressed as a percentage. There is nothing better than examples to illustrate a point, is there?
Example: John wants to buy a house that costs $500,000. He has been putting some money aside for years and currently has $50,000 to pay a deposit. For the rest, $450,000, he needs to take out a loan in order to buy the house. To calculate it, we need to divide the amount you want to borrow by the total value (or the selling price) of the property:
Loan to Value ratio= Loan/Property Value
In our example, we have to divide $450,000 by $500,000 and the result is 90%. Frankly, this is a high LTV ratio and it’s not certain whether the bank will agree to lend John the money.
It depends on many other factors, such as the bank, the income of the borrower, credit history and others. If John doesn’t meet the criteria, he needs to find some additional money for a larger down payment.
Importance of LTV Ratio
The LTV ratio is very important for banks. In the previous paragraph, I mentioned that it is part of their risk management. It helps them evaluate how risky a loan is. The riskier a borrower is, the more difficult will be for them to be approved. What’s more, a higher risk usually means higher costs, higher interest rate and additional insurance.
Mortgages are secured loans and their collateral is the property. This, on the other hand, means that should you fail to make payments or face other financial difficulties, the bank may take back your home. This is also known as foreclosure. Consequently, they will try to sell the property and take back the money they have lent.
Banks don’t need properties, they need cash which they can lend and benefit from the interest. And if they have given you 75% of the property’s price, it means they can sell it at a cheaper price and quickly get their money back. Also, banks know that prices change – they can go up, but also they can plummet. What happens if the bank secures 100% of the value and there is a collapse of the housing market with prices going down?
Consequences of High LTV
The lower an LTV ratio is, the better the loan terms will be. For instance, if John could make a larger down payment and have a ratio of 70%, then for sure his interest rate will be lower than his current at 90% LTV.
If a bank has to give 90% or even more to a borrower for a purchase, that’s a sign that there is a higher risk. Even though, as I previously said, it’s not the main factor, it does have a serious effect on the total costs of the loan.
Loans With 100% LTV
There is some good news. I know that many people can’t afford even a 5% down payment. There are several types of loans which can guarantee you up to 100% of the property’s value. One of them is the so-called VA loans (loans guaranteed by the US Department of Veteran Affairs). Only active-duty members, veterans or their spouses are able to qualify.
Other loans that require a very low down payment (high LTV respectively) are FHA mortgages. These mortgages are insured by the Federal Housing Administration and have less strict requirements.
Loans secured by Fannie Mae and Freddie Mac also allow the borrower to have a high LTV ratio.
LTV is a very important financial ratio that shows how much money you will receive from a bank for the house you want to buy. This ratio is critical when a bank decides whether to approve your application or not. That’s why you’d better keep it low. Good luck.