The loan to value ratio is a risk measurement ratio for loans that allows a lender to determine the relative risk of approving a consumer for a loan. The higher the loan to value (LTV) the greater the risk for the lender and conversely the lower the LTV ratio the lower the risk for the lender. Lenders approve borrowers for mortgages based on the risk of providing the mortgage.
The loan to value ratio helps lenders assess risk. Furthermore, lenders typically charge borrowers with higher LTV’s higher interest rates to offset the increased risk of providing the mortgage. Borrowers must purchase private mortgage insurance if they have a loan to value ratio of over 80%. Private mortgage insurance protects lenders against losses resulting from borrower default and foreclosure. Once the borrower’s debt is paid down to the point where the LTV is below 80%, borrowers can cancel the private mortgage insurance.
The loan to value ratio is stated as a percentage by dividing the value of the property by the loan mortgage debt. For example, a property that is valued at $200,000 and has a $50,000 mortgage has a loan to value ratio of 25%. This is calculated by dividing $50,000 by $200,0000 ($50,000/$200,000).
Why Lenders Use a Loan to Value Ratio to Approve Borrowers
As explained above, loan approval is primarily based on the risk of providing that loan. The collateral of the property being used to qualify for a mortgage and its value directly affect the risk level associated with the loan. The value of the collateral helps a lender determine whether the proposed loan amount compared to the value of the property has enough equity in the event the borrower falls behind on mortgage payments.
The more equity a borrower has, the greater likelihood they can get approved. Equity is the difference between the property value and the loan amount. A loan to value ratio is important for lenders because if a borrower cannot afford mortgage payments after they have already received financing, the borrower needs to have enough equity for the lender to recoup their debt and earn a profit on their investment.
Every lender uses the LTV ratio as one of the main qualification methods for loan approval. When a borrower applies for financing, they can only qualify with a loan to value ratio with a maximum 80% LTV, although government financing programs such as FHA or the VA go higher, sometimes up to 97% for FHA loans and 100% for VA loans.
The higher the LTV, the greater the risk for the lender because if values go down and the borrower can’t afford payments, the lender may actually lose money because there may not be enough equity for the lender to recoup their loan. This is because when a loan to value ratio is high, such as above 80%, the lender will have a difficult time selling the property for an amount high enough to cover the balance of the loan.
Maximum Loan to Value Ratio for Loan Approval
All lenders have different maximum LTV ratios that they use in qualifying a borrower for a mortgage. The standard maximum LTV for most conventional lenders is 80%. This means that the property must have at least 20% equity to qualify for a mortgage. For example, a property that is worth $500,000 can have a maximum $400,000 loan. This would be an 80% LTV.
FHA loan programs permit borrowers to have up to a 97% LTV, however they require all borrowers whose equity surpasses 80% to purchase private mortgage insurance. Private mortgage insurance is a requirement to ensure that lenders are protected if a borrower cannot afford their mortgage. In addition to protecting lenders interests, it forces borrowers to have more “skin in the game” by paying higher rates than others.
“Skin in the game” refers to the condition that a party has vested interest, typically a financial interest to ensure that they pay payments on time because of the risk of losing the skin that they have already invested into the mortgage. Clearly when a borrower is willing to pay higher interest rates and have private mortgage insurance, there is a greater likelihood that they will do everything in their power to maintain property ownership.
Private lenders, such as hard money lenders lend up to 70% LTV. Anything higher than 70% is rarely approved and if it is, they carry a significantly higher interest rate than standard mortgages.