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, also called LTV for short, 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 it is, the more risk the lender is taking on by lending you money, and 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.
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, trade 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.
How does LTV affect your loan terms?
While LTV is commonly used with several different types of loans, the ratio can affect you a bit differently with each one.
Mortgages. Of all the different types of secured loans, your LTV will have the greatest impact on a mortgage.
For starters, if your beginning LTV is higher than 80% on a conventional mortgage, you may be required to pay private mortgage insurance, which can cost you between 0.3% and 1.5% of your loan amount annually. On a $250,000 loan, that's $62.50 to $312.50 added to your monthly mortgage payment.
A high LTV resulting in a higher interest rate will also have a much bigger impact on your wallet with a mortgage than with other types of secured loans. This is primarily because mortgage repayment terms are so long.
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.
Finally, it's possible for you to owe more on your home than it's worth, which usually happens when your home's value drops but your loan balance doesn't drop with it. After the housing market collapsed in the mid-2000s, almost a quarter of Americans were underwater on their mortgages, which happens when the loan's LTV exceeds 100%. This is also sometimes referred to as having negative equity.
If this happens, it can be tough to sell the home unless you have enough cash on hand to pay the difference.
Reverse mortgage. Like the term suggests, a reverse mortgage is a type of loan where you receive monthly payments instead of making them to a lender. These loans are designed for people 62 or older as a means to supplement retirement income.
You don't need to own your home free and clear to qualify for a reverse mortgage – although it is preferable – but you do typically need to have a loan-to-value ratio of 50% or less to have a chance of getting approved.
Keep in mind, though, that the higher your LTV on your original mortgage, the lower the payout you'll receive from a reverse mortgage. As a result, it may not make sense to apply for one unless your LTV is extremely low or you own the home outright.
When a higher LTV may make sense
Having a high LTV can cost you more money, but there are some situations where it may make sense to get a secured loan without a big down payment.
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 special programs with no money down at all. Also, some government-insured loans, including U.S. Department of Agriculture and U.S. Department of Veterans Affairs 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 your cash toward a home, then something happens and 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.
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