Understanding how the loan-to-value (LTV) ratio plays into mortgage lending is an important principle for all borrowers to understand. The loan-to-value ratio is the amount of money the borrower needs to purchase a property of a certain appraised value.
For example, if a borrower intends to purchase a $150,000 home and has a down payment of $20,000; he’ll need a $130,000 loan. The LTV for this example would be $130,000/$150,000 or 87% LTV.
The LTV component is a primary risk factor lenders consider when scrutinizing a mortgage loan application. Borrowers with exceptional credit and a substantial down payment typically qualify for the most financing (over 80% LTV). For those with stellar credit records, some lenders will extend 100% financing.
The Importance of a Healthy Down Payment
One way lenders determine how much loan to approve is through the borrower’s down payment. The down payment is a percent of the sales price that the borrower produces. The higher the down payment, the less of a risk the borrower is to the lender. For instance if the borrower seeks a $250,000 mortgage with an LTV of 80%, he would need to produce a 20% down payment or $50,000.
One hurdle borrowers run into is finding the necessary amount of money for the down payment. Not all borrowers have enough reserves to produce a large down payment. In addition to savings, borrowers can tap into:
- 401 (k) plan
- Sell stocks
- State government run subsidy program (requirements differ per state)Friends and family members
In addition to finding the money, sellers will sometimes help buyers with the down payment through a carry-back mortgage. The notion allows sellers to leverage their cash to compete in a difficult market.
How the Appraisal Influences the LTV
Before obtaining a loan, the borrower’s property must undergo a professional appraisal. Regardless of the asking price, the appraisal report will provide the approximate value on which the lender can base loan recommendations.
Should the appraisal come in considerably lower than the asking price and the borrower needs more than 80% financing; the deal may fall through. However, borrowers can take a few steps to ensure that they not only receive a fair appraisal but determine if the property price is artificially inflated:
- Conduct due diligence by researching other comparable home sold in the area
- Track the property’s sale record to determine how much the home appreciated
- Ask the appraiser questions prior to the site visit about knowledge of current neighborhood and market appraisal trends
- Review the appraiser’s report to determine if it includes all of the home’s features and benefits (which could sway the report toward a lesser value if missing)
Although the appraisal sets the tone for the lending process; it is by no means set in stone. Borrowers can have the property re-appraised if they believe the appraiser made glaring mistakes on the report or completely under-estimated the property’s valuation as compared to other comparable properties sold within the last two years.
Borrower’s Credit Rating Impact on the LTV
Lenders are less likely to offer considerable financing to borrowers with low credit scores (typically under 620). Typically LTV ratios under 80% are associated with high risk borrowers. These borrowers have access to only the higher rates due to:
- High debt-to-income ratio
- A track record of making previous late mortgage payments
- High loan amounts (including personal and credit cards)
- No or sketchy income documentation
- Low down payments or cash reserves
Borrowers with a higher the credit rating receive the lower rates and higher financing because they are considered to be less of a default risk than those with black marks on their credit report.