Home Mortgage Terms: Loan to Value Demystified
You’ve read here before about the sometimes confusing language lenders use on a daily basis. When financing a property you’ll encounter these terms and if your loan officer isn’t careful, will use them when communicating directly with you in “lender lingo” instead of everyday language. It’s easy for that to happen because after all, the loan officer and pretty much everyone who works at the mortgage company is in the business and well, that’s just how they talk. Any industry is the same. But there is one term that’s right up there with a few others in levels of importance and that’s “loan to value” or LTV. It’s important because it tells the lender the level of risk associated with financing a property as it relates to buyer’s equity.
Loan to value compares the amount borrowed with the current market value of the property. A low LTV loan means the borrower is putting down a larger down payment compared to a high loan to value loan. Less down payment means less initial equity owned by the borrowers and the risk level is slightly raised yet it is only a piece of the approval puzzle.
Loan programs can require more or less down payment, depending upon the individual loan. For example, conventional loans, those underwritten to standards issued by mortgage giants Fannie Mae and Freddie Mac ask for at least a 20 percent down payment, resulting in an 80 loan to value. If the sales price of a home is $400,000, with a 20 percent down payment the loan amount is 80 percent of $400,000, or $320,000.
However, borrowers can elect to put less down and still get a conventional loan. Instead of 20 percent down, the borrowers want to put down just 5.0 percent. That’s still okay with Fannie and Freddie but to offset the risk of initial reduced equity from the buyers, they will require a mortgage insurance policy that will protect the lender from the difference between 20 percent down and what the borrowers actually put down. In this example with a 5.0 percent down payment, the loan to value is 95.
Because of the lower down payment and the addition of mortgage insurance, lenders may require a higher minimum credit score compared to someone who put down 20 percent or more. It’s completely up the lender but most do ask for higher scores when there is only a 5.0 percent down payment and a 95 loan to value. Fannie also has a special program asking for just 3.0 percent down making the LTV 97.
There are three primary government-backed loans, VA, FHA and USDA mortgage programs. All three allow a very high loan to value ratios. In fact, VA and USDA initial loans can actually be higher than the purchase price. These two programs require no down payment so the LTV is 100. FHA loans ask for a minimum down payment of 3.5 percent so the LTV is then 96.5.
There is a higher level of risk for such loans but again it is offset with a type of mortgage insurance. VA loans are insured by the funding fee, which is 2.15 percent of the sales price but can be added back into the loan and almost always is. That would mean a home selling for $100,000 would have a final loan amount of $102,150. The LTV is then 102. For USDA loans, the mortgage insurance policy is called the “guarantee fee” and today is 2.75 percent of the loan amount. Yet when lenders evaluate these loans and issue the approval, it’s the initial loan to value requirement that must be met. For instance, with an FHA loan, there needs to be evidence of at least a 3.5 percent down payment. After adding in the required upfront mortgage insurance premium the final loan will be higher than the original 96.5 percent LTV.
Now let’s take the concept of a loan to value to another level and look at combined loan to value, or CLTV. Remember, Fannie Mae and Freddie Mac ask there be mortgage insurance if there is less than a 20 percent down payment but there is another way to get around that requirement and still not have mortgage insurance with the loan. This is accomplished using not one but two mortgages to complete the transaction, a first and a second mortgage.
Looking at the same $400,000 home, a buyer could put down 10 percent or $40,000 and a second lien would be placed on the property for the other $40,000 keeping the first conventional mortgage at the 80 percent benchmark. In this example, there are two loans on the property, one at $320,000 (80 LTV) and $40,000 (10 LTV) for a CLTV of 90.
Finally, we need to address refinancing a mortgage and how loan to value is used. When the property is first purchased, the lender uses the lower of the sales price or the appraised value. It’s always the appraised value that determines the value lenders use when evaluating a loan application. During a refinance, the lender orders the appraisal and the subject property is compared to similar properties in the area. Additionally, borrowers can roll in the associated closing costs on the loan given sufficient equity. Government-backed loans restrict the newly refinanced loan to be no greater than the initial loan. Conventional loans limit a first loan to 90 percent of the appraised value, or an LTV of 90. Conventional loans also allow for a first and a second mortgage with a CLTV of 90, much like a purchase loan. If the appraised value comes in lower and the LTV or CLTV is too high, the borrowers have the option of paying the mortgage balance down to meet the LTV requirements or, if the closing costs are pushing up the amount borrowed, adjusting the interest rate and receive a lender credit toward some or all of the fees.
Mortgage programs all have a required initial maximum loan to value and lenders really can’t override this initial amount. Yet if you’ve found a home now that you want to buy but aren’t sure how much money you need for a down payment and closing costs, a quick phone call with a loan officer can provide you with your options.