About Maximum Loan-to-Value Ratio:
A loan-to-value ratio (LTV) compares the amount of a loan to the value of the property it is being used to purchase. A maximum loan-to-value ratio is the highest LTV a lender is willing to accept. In mortgage lending, for example, the higher the loan-to-value ratio, the larger the percentage of a home’s purchase price that is being financed through borrowing. Since the home serves as collateral for the loan, lenders use the loan-to-value ratio as a measure of the risk they are taking on.
- A loan-to-value ratio compares the amount of a loan, such as a mortgage, to the value of the property it is being used to purchase.
- Lenders use the loan-to-value ratio as a measure of the risk involved in a particular loan.
- The maximum loan-to-value ratio is the largest percentage a lender will accept.
- The larger the down payment a borrower makes, the lower the loan-to-value ratio.
- Down payment requirements vary by lender and loan program to loan program.
How Maximum Loan-to-Value Ratio Works?
Lenders set maximum loan-to-value ratios to ensure that they can get their money back (or at least a good chunk of it) if the borrower defaults on the loan and the lender has to seize and sell their collateral. The lower the loan-to-value ratio is, the less risk the lender is assuming. Maximum loan-to-value ratios are used with many types of loans, particularly with home mortgages and auto loans.
Some home loan programs that are designed specifically for low- to moderate-income and first-time home buyers allow for relatively high maximum loan-to-value ratios. Many of these loans, which are offered through private lenders, such as banks, are sponsored and subsidized by state and local governments, the Federal Housing Administration (FHA), and the Veterans Administration, among others. Their guarantees reduce the lender’s financial risk.
Calculating Maximum Loan-to-Value Ratio:
Lenders rarely offer loans that will cover 100% of the purchase price of a home or other asset. Instead, the borrower is required to make a cash down payment. In the case of some government-subsidized mortgages, that can be as low as 3%. (Two exceptions are VA loans and USDA loans, which are partially subsidized by the Veterans Administration and U.S. Department of Agriculture, respectively; they allow down payments as low as 0% in certain cases.)23 Other lenders require higher down payments, such as 10%, 15%, or 20%. A 20% down payment was once the common standard.
Suppose, for example, that you want to buy a $200,000 home and are planning to make a down payment of 20%, or $40,000. That means you’ll need to borrow the remaining $160,000. In this case, the loan-to-value ratio would be 0.80 ($160,000 divided by $200,000), or 80%.
On the other hand, if you were able to buy that same home with a 3% down payment, such as through a Fannie Mae loan, your down payment would be $6,000, and your mortgage would cover the remaining $194,000. Here your loan-to-value ratio would be 0.97 ($194,000 divided by $200,000), or 97%.
Notably, if you make a down payment of less than 20% on a conventional mortgage, the lender will probably require you to purchase private mortgage insurance or PMI. The purpose of PMI is to give the lender additional protection in the event of a default. If the equity you have in your home rises to a point where it equals or exceeds 20% of the original purchase price, you can ask the lender to cancel the PMI.