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The path through the murky waters of financial jargon can be frustrating, and oftentimes, you will need to cough up a pretty penny for a financial advisor.
This holds even greater significance when you are trying to access a mortgage to finance your home, and the terminology sounds like word salad.
To make the process easier for you, let us look into one of these terms - the loan-to-value ratio.
A loan-to-value ratio is a financial ratio lending institutions use to compare the size of a loan subject to the value of the property and the deposit amount. It is thus an assessment of the amount of risk a lender is taking on by issuing a secured loan.
This article will answer helpful questions associated with this topic, including what the loan-to-value is, how it affects your loan access, factors that impact this ratio, and how you can lower your loan-to-value ratio.
Read on for more.
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How The Loan-to-Value Ratio Works
The LTV ratio is a tool used by money lenders to compare the mortgage price with the appraised prosperity value. With this ratio in mind, the lending institution can determine whether you will require private insurance on your mortgage.
The loan to value ratio is easy to compute despite the seemingly complex terminology. The lending institution will divide the total amount of the loan by the value of the property that you are interested in buying.
Thus, if you are applying for a loan of $400,000 and the property's appraised value is $600,000, then your loan-to-value ratio is equal to ((400,000/600,000)*100) or 67%.
This means that you have $200,000 in your deposit and require an additional $400,000. When it comes to the loan-to-value ratio, the bigger your deposit, the lower your loan-to-value ratio will be.
For instance, using the same example, if you have a deposit of 250,000 and the property's appraised value is $600,000, you will need an additional 350,000 to purchase the house.
In this instance, your loan-value-ratio will be equal to ((350,000/600,000)* 100) or 58%.
What is The Ideal Loan-to-Value Ratio?
The ideal loan to value ratio for most conventional loans is anything under 80%. The lower your loan to value ratio, the more likely that it is you will access a loan without requiring private mortgage insurance.
According to the financial gurus at Forbes, most lenders will only approve your loan depending on the value of the loan-to-value ratios.
If the value of your loan-to-value ratio is above 80%, most lenders will not approve your loan. The ones that do will require you to buy mortgage insurance as a kind of security if you default on your loan.
Why You Should Know Your Loan-to-Value Ratio
The loan-to-value ratio is important because it determines whether lenders will finance your mortgage and thus affects your ability to purchase a property.
Most people looking for mortgage financing but have a high loan-to-value ratio have to pay thousands more in additional costs from private mortgage insurance.
However, there are also some other factors why a loan-to-value ratio is vital and why keeping it as low as possible will serve your best interests.
Most Lenders Have Max Limits on Loan-to-Value Ratio
Knowing your loan-to-value ratio is essential when selecting a lending institution to apply for a loan from. This is because most lenders have a maximum loan-to-value ratio.
The good news is that some lenders offer a maximum loan-to-value ratio of 90 to 95%. You will only need a small deposit to secure a loan in such a situation.
Knowing your loan-to-value ratio can therefore save you a lot of time; and leg work.
Access to Larger Loans and Low-Interest Rates
Knowing your loan-to-value ratio can help you access a larger loan. A low loan-to-value ratio means you can access a larger amount, but at lower interest rates.
While you can access a loan with some lenders with a high loan-to-value ratio, you will often be at risk of very high-interest rates.
In addition to lower interest rates, some lenders can sweeten the pot with additional offers such as discounts or better package offers.
Know if You Will Need Private Mortgage Insurance
Knowing your loan-to-value ratio is also critical for financial planning. You can then make plans beforehand to accommodate the additional private mortgage insurance costs if your loan-to-value ratio is too high.
Contrary to common belief, you don’t have to wait to go to a lender to know your loan-to-value ratio. In fact, knowing this information helps you stay better prepared.
Factors That Affect Your Loan-to-Value Ratio
It is important to be aware of the factors which may affect your loan-to-value ratio so that you are not caught flat-footed when it is time to proceed with your purchasing goals.
An important aspect to note is that the main factor affecting the value of your loan-to-value ratio is the value of your property after appraisal.
Several factors will impact your property’s appraised value. These include the following:
- The condition of the proposed property - newer and well-maintained property will usually be appraised as of higher value than older and less well-maintained houses.
- Location: As the saying goes, when it comes to property, the most important aspect is location, location, location. Similar houses will have different appraised values based on where they are located.
- Size of the property: Larger properties attract a higher valuation when compared to smaller properties, at ceteris paribus.
- Property type: Different types of houses or properties will have different values upon appraisal. For instance, an apartment building will not have the same value as a freestanding house.
How to Lower Your Loan-to-Value Ratio
Having a high loan-to-value ratio is not a death sentence. You can reduce this value by increasing the size of your deposit.
As a good rule of thumb, knowing your lender's loan-to-value limits is crucial to determine how much you need to add to your deposit to match the limit.
In closing, the LTV ratio is an important financial instrument that lenders can use to gauge their level of risk in financing a given loan based on the value of the property and the size of the deposit.
To recap, the following two aspects stand out from this article:
- The lower the loan-to-value ratio, the easier it is for lenders to approve your loan.
- The higher the amount of your deposit, the lower your loan-to-value ratio is.
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