When you apply for a mortgage, one of the things that lenders want to know is what portion of the value of the home you wish to finance. In other words, they want to know how much of a down payment you are going to be making in relation to the overall cost of the home. This percentage is known as the loan-to-value ratio (LTV).
To calculate the LTV, you divide the total amount of the mortgage by the appraised value of the property:
Mortgage ÷ Appraised Value = LTV
If you are buying a property with an appraised value of $200,000 and you apply for a $160,000 mortgage, then:
$160,000 ÷ $200,000 = 0.80 or an LTV of 80%
This percentage is important to lenders because the higher your LTV, the lower your home equity. And lenders view borrowers with low equity as having a greater risk of defaulting on their loan.
As a general rule, lenders require those who take out a mortgage with an LTV greater than 80 percent, to pay for private mortgage insurance. This protects them in the event a borrower defaults by ensuring that the outstanding balance of the loan will be paid off.
Lenders may also charge higher mortgage interest rates on high LTV loans than on loans where the down payment is at least 20 percent. And they may require a second appraisal of a property before they will approve the loan.
To avoid these pitfalls, it’s a good idea to keep the LTV in mind when searching for a home. Start by getting pre-approved for a mortgage before you go house hunting. This enables you to calculate how much you can afford to spend.