What is loan-to-value ratio?

When taking out a loan to pay for certain assets, like a home or car, you might hear your lender talk about its loan-to-value ratio. Also called LTV, this percentage helps lenders mitigate their own risk and also ensures that borrowers are taking out the right loan in the context of their financial situation. 

Loan-to-value ratio matters to both lenders and homeowners, and a lower value is best. Fortunately, it’s easy to calculate this number on your own.

What is loan-to-value ratio (LTV)?

The name may have given it away, but LTV is the ratio of your loan compared to the value of the asset it is used to purchase. In terms of getting a mortgage, LTV is the ratio of the loan amount you (the prospective homebuyer) want to borrow as a factor of the property’s actual market value.

Loan-to-value ratios are expressed as a percentage. Each lender will set its own LTV requirements; whether you’re trying to purchase a home, car, boat, or other tangible asset, you’ll only be able to borrow up to a certain amount in order to meet that maximum loan-to-value ratio limit. 

Try to borrow beyond that, and you might be required to offer a larger down payment or even negotiate a lower purchase price in order to get approval. 

How to calculate loan-to-value ratio

Calculating a loan-to-value ratio is very simple. You just need to divide the loan amount by the market value of whatever you’re trying to purchase, then multiply by 100.

Let’s say a buyer wants to borrow $200,000 for a home with a current market value of $245,000. Their LTV on that mortgage loan would be 81.6%

200,000 / 245,000 = 0.816   →   0.816 x 100 = 81.6% LTV

If those numbers were reversed, though, and the buyer wanted to pay $245,000 for a home that was only worth $200,000, their LTV would be 122.5%

245,000 / 200,000 = 1.1225   →   1.225 x 100 = 122.5% LTV

Why is loan-to-value important?

From a lender’s perspective, loan-to-value is important because it limits the risk that the lender takes on by issuing the loan. 

If a borrower defaults on a loan, the lender is able to seize whatever property acts as collateral on that loan. When it comes to a home mortgage loan, for instance, a lender can foreclose on a house and sell it elsewhere to recoup their losses. If the homeowner owes more on their loan than the value of the home, however, the bank isn’t able to recover their losses entirely.

Let’s see this in numbers:

• A homeowner owes $200,000 on a home with a $180,000 market value (LTV of 111%).
• They actually owe the bank $20,000 more than that property is worth. This is called negative equity, or “being upside down” on the loan. 
• The homeowner defaults on that loan, and the bank seizes the property. However, they aren’t able to recoup the entire $200,000 debt that they are owed because the home isn’t actually worth that much in the current market.
• The bank eats the loss of $20,000 (or more). 

To avoid this situation, lenders are particular about the maximum LTV they are willing to accept.

From a buyer’s perspective, maintaining a reasonable loan-to-value ratio on a home allows a homeowner to maintain some equity in it. If they need to sell the property at any time, that equity helps ensure that they walk away from the transaction without owing the bank money out-of-pocket. 

Here’s another example of LTV in action:

• A homeowner owes $200,000 on a home with a $180,000 market value. (LTV of 111%)
• They have $20,000 in negative equity on the property.
• The homeowner takes a job in a new town and suddenly needs to sell their home. Since the current market value is only $180,000, though, they’re unable to make more than that on the sale.
• The homeowner sells their home, but winds up having to pay their lender an additional $20,000 from their savings account at closing. 

To avoid this situation, homeowners should always aim to maintain a reasonable loan-to-value ratio in their property.

What’s considered a good loan-to-value ratio?

Arguably, the best loan-to-value ratio is the one that’s the lowest. This serves to protect both the lender and the homeowner in a slew of situations. 

If you’re wondering what LTV you should aim for when taking out a loan, though, the answer really depends on the type of loan you’re seeking and even the specific lender.

When it comes to mortgage loans, here are the common LTV requirements.

• Conventional home mortgage loans: Lenders often want to see an LTV of around 80%, though they might accept as high as 95% for the right borrower. 
• FHA loans: Allow for an LTV of up to 95%, depending on the mortgage amount. Some mortgage loans may be limited to an LTV of 85%. 
• USDA loans: Intended for rural development, USDA loans allow for an LTV as high as 100% (or, when certain fees are financed, greater than 100%). 
• VA loans: Only available to active duty service members, veterans, and select military spouses, a VA loan allows eligible borrowers to have an LTV up to 100%. 

Borrowers may find that the higher their home’s LTV, the higher the interest rate they are offered on their home loan. (Find out what else affects mortgage rates.)

Loan-to-value ratios are also important when buying or refinancing an auto loan. While this can also vary by lender and even the age or the type of vehicle being purchased, the maximum LTV allowed by auto lenders is usually around 130%. 

Avoiding private mortgage insurance

If you take out a conventional home mortgage loan with an LTV of more than 80%, your lender will typically require the purchase of private mortgage insurance. Also called PMI, this insurance protects the lender in case you default on your mortgage loan.

Borrowers can be required to pay PMI — which usually costs between 0.2% and 2% of the total loan amount each year — until their remaining principal balance reaches 78% to 80% of the loan’s original LTV. 

How to lower your LTV

There are many times where you may want, or need, to lower your loan-to-value ratio. But how?

If you are looking to buy a home, you can lower the LTV on your mortgage loan by doing the following:

• Negotiate a lower sales price. If you pay less for a property, you’ll automatically lower your LTV ratio, all other factors the same. For example, a home valued at $250,000 would have an LTV of 88% if you settle on a purchase price of $220,000 (assuming you finance the entire purchase). Negotiate the seller down to $205,000, though, and your LTV drops to 82%. 
• Offer a larger down payment. In some cases, you may need to put more down on your home purchase in order to reduce your LTV. The higher the down payment, the lower the LTV.
• Pay closing costs in cash. Rather than rolling your closing costs into your new home purchase, consider paying those out-of-pocket. This will save you from paying interest on those costs, and can also help you get a lower LTV. 
• Opt for a different type of mortgage loan. Some lenders may have a maximum LTV of 90%, while others might allow for 95% to 100%. Depending on your property, the purchase price, and your down payment, looking into other mortgage options could help you qualify for a loan with a higher LTV. 
• Have your home appraised. If your home’s value has increased since you bought it, you might actually have more equity than you think. By getting an up-to-date appraisal, you can see exactly what your current LTV is, compared to your remaining principal balance.

If you already own a home, but find that your loan-to-value ratio is higher than you’re comfortable with, here are some ways you can work to reduce it:

• Make additional principal payments. Each month, a portion of your mortgage payment goes toward your principal balance while another portion goes toward interest for your lender. By making additional payments toward your principal, you will reduce this balance faster than scheduled and automatically lower your loan’s LTV. 
• Refinance your mortgage loan. Refinancing your mortgage loan can allow you to reduce your repayment term, lower your interest rate, or both. This can help you pay down your principal balance sooner and lower your LTV along the way.

Maintaining a reasonable loan-to-value ratio can protect borrowers and lenders alike. Owing too much on a particular asset is always a risk, so borrowers should do what they can to lower their LTV as much as possible.