What is the Loan-to-Value?

When you reach the application stage of securing your loan, the term loan-to-value is something you will hear frequently. The loan-to-value is simply a ratio—the percentage that you get when you divide the mortgage amount by the value of the property.

When it comes to determining property value, there are some differences between a purchase and a refinance loan:

Purchase loan value
When purchasing a home, there are two values we look at. The first is the sales price, which is the amount agreed upon in the sales contract. The second is the appraised value, which is determined by a professional appraiser.

Perhaps you’re wondering why there are two values? Shouldn’t the two values be the same? Very often they are the same. However, they might differ if, as the buyer, you are lucky enough to negotiate a lower sales price from the seller! On the other hand, you might want a property so much that you are willing to pay more than the asking price, outbidding all other potential buyers to guarantee that you get the house. Lenders use the two values—sales price and appraised value—to support each other, giving a better sense of the property’s value.

Refinance loan value
When refinancing an existing loan, there is no sales contract, so the appraisal is the only way to determine the property value. Sometimes for very large mortgages, a second appraisal or a supporting “review” appraisal is required for the lender to feel confident in the property’s value.

Calculating loan-to-value
Because there is no sales price to work with on a refinance mortgage, we calculate the loan-to-value using a different formula than we would for a purchase mortgage. Here’s the difference:

  • For a purchase mortgage, divide the mortgage amount by the lower of the sales price or the appraised value. You use the lower figure of the two because it is a more conservative valuation of the property. Generally, these two figures will be very close to each other, and very often they are the same!
  • For a refinance mortgage, divide the mortgage amount by the appraised value.

Let’s try an example.

Say the purchase price of your new home is $100,000 and the appraised value is $102,000. And let’s say you are making a down payment of $15,000. That means you will need an $85,000 mortgage to make the purchase.

To calculate the loan-to-value, you would divide $85,000 by $100,000 (the lower of the sale price and the appraised value). In this example, the loan-to-value is 85%.

Why loan-to-value is important
Why do lenders talk so much about loan-to-value? Because a loan-to-value ratio is an easily calculable percentage that appears in all loan program guidelines. It’s a thumbnail approach to assessing the risk involved when using the property as collateral. The rule of thumb is: the higher the loan-to-value, the greater the risk; and the lower the loan-to-value, the lower the risk.

You can clearly see that an 50% loan-to-value is less risky for the lender than an 80% loan-to-value. On a $100,000 purchase, the difference between these two loan-to-values is the difference between a borrower who has invested $50,000 to purchase the property, and a borrower who has invested $20,000 to purchase the property. Because the first borrower in this example has taken a greater financial risk by personally investing $50,000, the lender’s risk as far as the collateral is concerned is less.

The advantage of low loan-to-values
There is an advantage to making your loan-to-value ratio at 80% or less—either by making a large enough down payment during the purchase or by not borrowing on your home equity beyond 80% loan-to-value. As an industry practice, lenders require borrowers to help reduce the risk on loan-to-values loans above 80%. Lenders do this by requiring buyers to purchase mortgage insurance on the portion of the mortgage above the 80% mark. GE, GMAC, PMI, and many other national mortgage insurance firms will accept that risk in return for payment of a mortgage insurance premium.

The mortgage insurance requirement for above-80% loan-to-value loans is a part of the loan program guidelines. If you require a greater-than-80% loan-to-value mortgage, some loan programs will allow the mortgage insurance premium to be waived if you agree to pay a slightly higher interest rate on the loan. Remember, if your loan-to-value is 80% or below, there is no mortgage insurance required!