When it comes to buying a home, it’s easy to think about the fun aspects that come with a new house – but the first, and most important, step in the process is obtaining a mortgage. The lending process requires a comprehensive review of your finances in order to determine your loan eligibility, and one factor you should be aware of early on in the mortgage process is the loan-to-value ratio and how it will ultimately play a role in determining your monthly mortgage payment.
Defining Loan-to-Value Ratio
A loan-to-value (LTV) ratio is calculated by dividing your loan balance by your home’s appraised value. Its purpose is to provide a comparison between the value of the loan you are seeking to take out versus the actual value of your home. Your LTV ratio will typically affect the mortgage rate you’re able to obtain.
- Lower LTV – You will usually qualify for a lower mortgage rate because you’re considered to be less risky, since you have more equity in your home.
- Higher LTV – You will likely notice your mortgage rate is on the higher end, since you’re considered more of a risk due to having less equity in your home.
Significance of Equity in Your Home
As we mentioned above, the amount of equity you would have in the home has a big impact on how low or high your mortgage rate will be and how much of a “risk” you’re viewed as to your mortgage lender.
The more equity you have in a home means you’re less likely to default on your mortgage – and in the event you did default, your lender would have a good chance of recouping the full amount owed in a foreclosure sale.
Understanding the Impact of Your Down Payment
The LTV ratio happens to be one of the main factors that go into determining your ability to obtain a mortgage – so how can you ensure you’re a good candidate for a home loan? For starters, be sure you understand the impact of your down payment. With a number of loan options available, in some cases, qualified buyers can put down as little as 3.5% toward the purchase price of a home.
While it may sound good (because – less money out of your pocket, right?), know that the smaller the down payment you’re able to put forward, the higher your LTV ratio will be.
This may mean you’ll end up with a higher mortgage rate, or in some cases, the inability to qualify for a mortgage.
Lower Down Payment = Mortgage Insurance
Perhaps you’ve determined that putting less than a 20% down payment is the right choice for you – and that’s OK! However, you should know that in addition to a higher mortgage interest rate, you’ll also likely be required to pay mortgage insurance (either private mortgage insurance or a mortgage insurance premium if you take out an FHA loan) to mitigate the risk you pose to your lender.
Keep in mind, some loan options, like a VA loan, do not require mortgage insurance, even if you put no money down.
Costs of Mortgage Insurance
Generally, a higher loan amount and LTV ratio coupled with a lower credit score will mean higher mortgage insurance premiums. Costs vary depending on a number of factors, but if you’re required to pay these premiums, be prepared for your monthly mortgage payment to jump in price. Also, you’ll find that if you have private mortgage insurance, it may be canceled once your balance reaches 80% LTV. However, if you have a mortgage insurance premium on your FHA loan and the LTV was 90% or more, you’ll owe this premium for as long as you have the loan.
How to Lower Your Loan-to-Value Ratio
If you find yourself in a situation where your LTV ratio is on the higher end, you don’t have to settle for all of the additional costs that come along with it. Here are a few ways you work on decreasing your LTV ratio and obtaining a mortgage that doesn’t cost you an arm or a leg!
Save Up for a Bigger Down Payment
If it turns out your LTV ratio is high and you would be required to pay mortgage insurance and/or have a higher interest rate, you could consider taking a step back instead of moving forward. That doesn’t mean you shouldn’t buy a home – but taking a bit more time to save for a larger down payment can be a huge cost savings up front and through the life of your loan!
Home Appraisal Value
In some cases, you’ll find that the home you’re in the process of purchasing appraises for a bit higher than the contract price, which will in turn, lowers your LTV ratio. Keep in mind, though, that it’s not common for homes to appraise for much more than the contract price. On the contrary, if your home appraises for less than the contract price, you may need to come up with more cash in order to seal the deal.
In either case, keeping in close contact with your real estate agent and lender during the appraisal time will help you make the best buying decision.
Paying More Principal
If you move forward with buying your home despite having a high LTV, consider making an extra principal payment or two each year in an effort to aggressively cut down your LTV ratio. This will also save you a significant amount of interest you would otherwise pay out of pocket over the life of the loan. Also, if your loan type allows for the removal of mortgage insurance once you hit an 80% LTV ratio, making extra principal payments when you have the funds to do so means you can cut out those excess costs sooner!