You’ll see a lot of three-letter acronyms thrown around as you shop for a home loan: APR, FHA, PMI. It’s enough to make your head spin. But there’s one mortgage acronym – LTV, short for loan-to-value ratio – that’s always puzzled me.
What I Thought The “V” Means
When it comes to understanding what really goes into determining your LTV ratio, I’m pretty clear on the first two letters. “L” stands for loan, or the amount of money you borrow from your bank – essentially, this encapsulates your home loan; “T” naturally stands for the word to. And while I know “V” stands for value, it can be tough to figure out exactly what that value represents.
For years, I thought the “V” in LTV came from the inherent value of a property, such as its tax or appraised value. Tell me I’m not alone – this interpretation makes sense in theory, right? After all, the value of a home should represent its overall worth.
At least, that’s what I thought.
What The “V” Really Means
Turns out, the value – at least when it comes down to the loan-to-value ratio – isn’t determined by a property’s appraised value… at least not all the time. Rather, it more often hinges on a property’s purchase price – in other words, what you thought the property was worth when you purchased it.
Why The “V” Matters
It’s actually up to the lender to decide whether to base the property’s value off its appraised value or its purchase price. Most banks and financial institutions will use whichever dollar amount is lower. This may not seem like a big deal, but when you crunch some numbers, you’ll realize that it has a huge affect on your home loan.
For example, let’s say you wanted to $30,000 in cash to use as a down payment on a new home. Now, pretend you found a home you love that has an appraised value of $200,000; you’re able to score a great deal and purchase it for $175,000. Factoring in your down payment, you’d be taking out a home loan of $145,000.
If we were calculating LTV by using the property’s appraised value – $200,000 – in the “V” spot, you’d get a loan-to-value ratio that looks like this:
$145,000 / $200,000 = 72.5%
At 72.5%, that LTV ration puts you well below the 80% threshold, meaning you’d be able to easily qualify for the best terms on a home loan: you’d skip private mortgage insurance altogether and get a low interest rate. But now let’s calculate the LTV based on the lower value number, the actual purchase price:
$145,000 / $175,000 = 82.8%
Using this calculation – which is the same one most lenders would use – you wouldn’t have at least a 20% equity stake in the property, meaning your loan value would be more than 80% of its value. Here you likely wouldn’t get the lowest mortgage rate, and would face mortgage insurance until your loan’s principal dipped under the 80% of purchase price mark.
Is It Fair?
That’s the question you’ve ultimately got to ask here. While the bank uses an LTV ratio to calculate the inherent risk of making a loan, it seems wrong not to give the buyer credit for that equity. If the appraised value is $25,000 above the purchase price, why penalize the buyer for his good negotiating skills or the seller’s urgency to unload the property at a low price? After all, if the bank were to take over the loan through a foreclosure, they’d surely be able to take advantage of the higher appraised value.
Readers, do you think the banks should calculate LTV ratios based on the higher number, giving buyers credit for the equity in their new homes?