Whether you’re borrowing to buy a home, car, recreational vehicle or a similar asset, you can expect to use the asset you’re buying as collateral for the loan. And depending on the type of loan you’re getting, its loan-to-value ratio can have a big impact on how much you pay in interest and what happens when you want to sell down the road.
The loan-to-value ratio, or LTV, is a factor lenders use to help determine the risk of a loan. LTV is an indicator of how much you’re borrowing relative to the value of the asset. The higher the ratio is, the more risk the lender is taking on by lending you money. It may charge a higher interest rate to compensate – or possibly even deny your application if your creditworthiness is in question.
Knowing how to calculate LTV and how it affects various loans differently is essential if you want to save as much money as possible when borrowing. In some cases, however, a high LTV can be worth it.
What Is LTV?
LTV indicates what percentage of a purchase you’re financing with an asset-secured loan. LTV in its simplest form is how much protection the lender has on the value of the property, says Kevin Leibowitz, founder of New York-based Grayton Mortgage and a mortgage broker. But what is loan to value and why does it matter?
Lenders use the loan-to-value ratio along with other factors to determine the risk of a loan. A high LTV signifies more risk because if you default on the loan, it’s less likely that the lender will get enough money by repossessing and selling the asset to cover the remaining loan amount and its costs associated with the process.
You can calculate loan to value by dividing the loan amount by the value of the asset. For example, if you’re buying a home and the loan amount is $250,000, but the value of the home is $275,000, your LTV is roughly 91%.
“The more money you put down, the less risky you are as the borrower,” says Dave Lowell, certified financial planner and founder of Up Your Money Game, a financial coaching and education company based in Utah. “So you’ll tend to get a lower interest rate.”
When you first apply for a loan, you can reduce the initial LTV by making a down payment or, in the case of an auto purchase, also trading in another vehicle as part of the sale. And, in general, a loan’s LTV decreases as you make payments toward its principal amount.
If you have good or excellent credit, your history of responsible credit use and on-time payments can help mitigate some of the risk a lender takes on with a high-LTV loan. And depending on your overall creditworthiness, you may still manage to get the loan at a favorable rate.
But if your credit isn’t in great shape, you may have a hard time getting approved with a decent rate unless you can find a way to reduce the LTV significantly.
What Is Combined LTV?
A combined loan-to-value ratio, or CLTV, is used when you have more than one loan on a property. For example, if you decide to take out a home equity loan, lenders will take the combination of your primary mortgage loan and the proposed home equity loan to determine your eligibility.
Most lenders have a maximum CLTV of 85%, but some may go as high as 100%.
What Is a Good LTV?
Mortgage experts generally agree that a good LTV is 80% or lower. This is particularly true for conventional loans, which typically require private mortgage insurance if your LTV exceeds 80%. This addition to your monthly payment can cost between 0.3% and 1.5% of your loan amount annually.
On a $250,000 loan, that’s between $62.50 and $312.50 added to your monthly mortgage payment.
But even with the less stringent LTV requirements, a high LTV can come back to bite you. If the value of your house falls, you could end up underwater on the loan, owing more than it’s worth. If this occurs, it can be difficult to sell the property or refinance your loan.
How Does LTV Affect Your Interest Rate?
Of all the different types of secured loans, your LTV will have the greatest impact on a mortgage. Regardless of the loan program, a higher LTV may result in a higher interest rate. This is because the lender is taking on more risk in the agreement.
For example, let’s say you have a $250,000 loan that you’re paying back over 30 years and your interest rate is 4%. With these terms, you’ll pay $1,193 toward principal and interest per month and nearly $180,000 in interest over the life of the loan.
But if your high LTV results in a 4.5% interest rate instead, your monthly payment and total interest charges would increase by $73 and more than $26,000, respectively.
It can also have a similar effect on other loans, such as auto loans. But because those loans typically have much shorter repayment terms, the total impact over the life of the loan isn’t as drastic. If you’re applying for a secured loan, ask the lender how the interest rate changes if you decide to put more or less down on the purchase.
Having a high LTV could still make sense in some situations:
The new loan will save you money. If paying rent is more expensive than making a mortgage payment, says Leibowitz, getting into a home before you have a big down payment could be worth it. Just make sure to consider all of the costs associated with a mortgage before you make a decision.
“For those that aren’t putting a large percentage down, the most important thing to ask,” Leibowitz adds, “is ‘Can I afford my mortgage payment, real estate taxes and insurance afterward? Do I have enough comfort to continue to make this payment?'”
If you’re in this position, note that conventional mortgage lenders typically allow you to put as little as 3% down, and some offer programs with no money down at all. Also, remember that VA and USDA loans offer up to 100% financing.
You want a hefty emergency fund. Making a significant down payment can reduce your interest rate on a loan. But if you drain your savings account, it can make you financially vulnerable.
“A lot of people view the LTV as an absolute, you never want to do mortgage insurance, it’s a waste of money,” says Leibowitz. “But it’s not the entire part of the story. You’ve got to make sure that you have enough reserves, and ask, ‘What does my financial picture look like after I buy this place?'”
If you put all of your cash toward a home and then you need cash to cover emergency expenses, you can’t get that money back from the lender.
Consider how much money you’re comfortable with putting down and how much you want to keep for a rainy day. While your monthly payment may be higher, that price could be worth the peace of mind.
You can get more value from the cash elsewhere. If you’re getting a low-interest loan, you may get more value by using some of the money you were thinking of putting down and investing it instead.
For example, if having a higher LTV increases your loan from 3.5% to 3.75% and you can get a 7% to 8% average annual return in the stock market, it may not be worth it to put all the money toward the loan.
Keep in mind, though, that while investing instead of going for a lower LTV may make more sense mathematically, it may not be a good approach if you’re generally debt-averse. Even if you could make more money in the market than what you’d save in interest, it may not be worth the added stress.
How to Lower Your LTV
Whether you’re about to make a purchase using a secured loan or you already have one in place, here are some ways you can reduce your LTV:
Make a larger down payment. Your LTV is based on your loan amount and the value of your home or vehicle. By putting down more money when you apply for the loan, you’ll immediately start out with a lower LTV.
Buy a more affordable home or car. If you can’t put more money down – or even if you can – you may also consider a more budget-friendly option. By looking for a more affordable home or vehicle, the same down payment will reduce the LTV even more.
Make additional payments. Once your loan is already in force, you can reduce your LTV by making additional payments. You can do this by adding some money to your monthly payment; paying half the amount due every two weeks, giving you one full extra monthly payment every year; or putting small windfalls like tax refunds and performance bonuses toward your balance.
Wait. Over time, the value of your home should appreciate, and your payments will reduce the principal value of the loan, both of which will consistently reduce your LTV. This process goes more slowly than the other options, but it happens naturally even if you don’t do anything extra.