Ever feel like important information gets lost in the sea of paperwork when dealing with mortgages? Two main pieces of that information often shrouded in confusion are loan-to-value (LTV) and combined loan-to-value (CLTV) ratios. But don’t let the technical terms intimidate you! After all, understanding these ratios is the key to a range of mortgage options for your clients.
This article is your guide to understanding LTV and CLTV. We’ll break down the calculations and explore what’s behind them and how they affect loan options.
What Are Loan-to-Value (LTV) and Combined Loan-to-Value (CLTV) Ratios?
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Loan-to-value ratio is a measurement that serves as a financial benchmark for lenders. It shows the percentage of a property’s value that’s financed by the primary mortgage. In simple terms, it indicates how much of the home’s value the borrower is borrowing to cover. Think of the loan-to-value ratio as a simple calculation of the loan amount against the value of the property.
The combined loan-to-value builds on the foundation of the LTV but with a broader focus. It is a ratio that compares the total amount of all loans secured by a property to the appraised value of the property. In other words, it takes into account all outstanding debt secured by the property itself. This includes not only the primary mortgage but also any existing home equity lines of credit (HELOCs) or second mortgages.
What Is LTV and CLTV Used For?
Both ratios play an important role in the mortgage industry, and they didn’t come out of the blue.
The loan-to-value ratio became important in the mortgage industry after a period of loose lending in the early 20th century. Back then, it was easier to get a mortgage even if a buyer didn’t have much saved for a down payment. This led to many people borrowing more than their homes were actually worth.
When the Great Depression hit, many people couldn’t keep up with their mortgage payments. Since they owed more than their homes were worth, they simply walked away from them. This left lenders with a bunch of houses they couldn’t sell for what they owed. After that, lenders became more cautious. They started using an LTV ratio to make sure borrowers had some cushion with a down payment. This meant that the borrower would also lose money if they walked away from the loan. The advent of the LTV ratio helped prevent another mortgage meltdown like the one that happened in the Great Depression.
However, looking at LTVs alone could miss potential risks. Borrowers with seemingly low LTVs may have taken on additional debt through HELOCs, putting them at higher risk of default. This led to the development and widespread use of the CLTV ratio as a way to evaluate the total debt secured by the property relative to its appraised value. The financial crisis of 2008 further emphasized the importance of understanding the total debt burden on a property, leading to increased scrutiny and regulation of CLTV ratios.
Difference between LTV and CLTV
The key difference between LTV and CLTV is their scope. LTV focuses on the initial investment through the primary mortgage, while CLTV paints a more complete picture by including all outstanding secured debt. Understanding LTV allows you to assess your client’s initial financial commitment and tailor your approach accordingly. Knowing the CLTV provides an important safety net. You can identify potential roadblocks caused by existing debt and present a more complete financial picture to lenders, ultimately securing the best possible loan options for your clients.
How to Calculate LTV and CLTV Ratios
Calculating LTV
So, the natural question is, how do you get all these magical ratios? Imagine you’re a financial architect carefully crafting a loan strategy for your client. The LTV serves as the foundation, representing the initial loan amount compared to the appraised value of the property. Let’s illustrate this with a specific scenario.
Suppose your client purchases a home valued at $400,000. They are a responsible buyer who comes prepared with a substantial down payment of $100,000. Using the LTV formula, LTV = (Loan Amount / Appraised Property Value) * 100%, we can calculate their LTV:
- Loan Amount = $400,000 (Purchase Price) – $100,000 (Down Payment) = $300,000
- LTV = ($300,000 Loan Amount / $400,000 Appraised Value) * 100% = 75%
A lower LTV, such as 75% in this case, indicates a smaller loan relative to the value of the property. This translates into a lower risk for the lender as there’s more equity (homeownership stake) for your client. This healthy LTV positions your client favorably when seeking loan approval and potentially securing a more competitive interest rate.
However, the story doesn’t end here, let’s add another layer of complexity.
Calculating CLTV
Fast forward a few years, and your client decides to renovate their home. To finance this project, they consider a Home Equity Line of Credit (HELOC). A HELOC allows them to borrow against the equity they have built up in their property. Here’s where the CLTV steps in, taking into account all additional loans secured by the property. So, let’s assume your client secures a $50,000 HELOC for their renovations. The CLTV formula, CLTV = (Sum of All Loans on Property / Appraised Property Value) * 100%, helps us assess the overall loan burden on the property.
- Sum of All Loans = $300,000 (Original Mortgage) + $50,000 (HELOC) = $350,000
- CLTV = ($350,000 Total Loans / $400,000 Appraised Value) * 100% = 87.5%
Your client’s CLTV, although higher than their initial LTV, remains within an acceptable range for most lenders. This demonstrates this homebuyer’s responsible use of their home equity while providing valuable context for future loan considerations.
Remember, a higher CLTV indicates a greater risk to the lender in the event of default.
Why LTV and CLTV Ratios Matter for Brokers and Borrowers
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As we’ve mentioned before, loan-to-value and combined loan-to-value ratios are important metrics for both mortgage brokers and borrowers because they directly impact loan approvals, interest rates, and access to certain loan products. Let’s take a closer look at how.
Impact on Loan Approvals and Interest Rates
For mortgage broker, LTV and CLTV are the primary tools for gauging a client’s eligibility for a mortgage. A low LTV, meaning the loan amount is a smaller portion of the property value, indicates a financially secure borrower. This translates into smoother loan approvals and potentially lower interest rates. These lower rates translate into significant savings for your clients over the life of the loan, making homeownership more affordable. Conversely, a high LTV raises red flags for lenders. They perceive a higher risk of default, potentially resulting in loan rejections or unfavorable interest rates. This not only hinders your client’s chances of securing a mortgage but also increases their borrowing costs.
And here’s the good news for mortgage brokers – your expertise can have a significant impact on your clients’ financial well-being. Specifically, you can help them achieve a more favorable LTV and CLTV for better loan terms, including lower interest rates and reduced fees. For example, you can educate your clients about increasing down payments, maximizing home equity, etc.
Impact on PMI
For borrowers with a down payment of less than 20% (resulting in an LTV exceeding 80%), private mortgage insurance (PMI) becomes a factor. PMI acts as an insurance policy for the lender, protecting them in case the borrower defaults on the loan. While it safeguards the lender, PMI comes with an additional monthly cost for the borrower. According to Investopedia, PMI costs typically range between 0.5% and 1.5% of the original loan amount per year. This translates into a monthly cost of roughly $42 to $125 for every $100,000 borrowed. The good news? Once the borrower reaches 20% equity in the property (through principal payments and potential property value appreciation), PMI is typically removed, significantly reducing the monthly mortgage payment.
Impact on Refinancing and Second Mortgages
LTV and CLTV ratios also play an important role in the context of refinancing and obtaining second mortgages. A low LTV, which means significant equity built up in the property, opens doors for refinancing. Lenders view borrowers with more equity as less risky, making them more likely to approve the refinance and offer lower interest rates. This allows your clients to potentially reduce their monthly payments or access additional cash through a cash-out refinance. However, refinancing the borrowers existing loan, may increase total finance charges over the life of the loan
A high CLTV, even with a low LTV on the primary mortgage, can tighten refinancing options. Lenders may be wary if the borrower is already heavily leveraged, potentially imposing stricter approval requirements or higher interest rates to mitigate risk.
When it comes to second mortgages, a low LTV, as we’ve already mentioned, indicates ample equity available for borrowing against. This equity serves as collateral for the second mortgage, making lenders more likely to approve the loan and potentially offer better terms due to the lower risk of default. A high LTV indicates limited remaining equity after considering the primary mortgage. This restricts the amount a borrower can potentially borrow through a second mortgage. Lenders may be hesitant to approve a large second mortgage if the combined loan value pushes the CLTV close to or exceeding 100%.
LTV and CLTV Ratio Requirements by Loan Type
It’s important to remember that LTV and CLTV requirements vary widely depending on the loan type. Why the variation? The lender’s risk tolerance plays a major role here. Government-backed loans like FHA, VA, and USDA loans are designed to promote homeownership and cater to a broader range of borrowers. To achieve this, they may allow for higher LTVs and potentially less stringent CLTV limitations.
On the other hand, Conventional loans offered by private lenders are considered riskier for the lender since they lack government backing. To mitigate this risk, Conventional loans often come with stricter requirements, such as lower LTV and potentially lower CLTV limits, compared to government-backed loans. Additionally, the type of property being financed also influences LTV and CLTV requirements. For instance, investment properties generally have higher LTV and CLTV requirements than primary residences.
Let’s break down these ratios for different loan types so that you can confidently advise your clients.
Conventional Loans
These loans are offered by private lenders and adhere to guidelines established by Fannie Mae and Freddie Mac. For Conventional loans, the LTV ratio is a key factor in loan approval and interest rate determination. LTV ratios for Conventional loans typically range from 80% to 97%, meaning the borrower is required to make a down payment of at least 3% to 20%. The CLTV ratio, which includes the total amount of liens on the property, is also considered and typically falls around 80% and should generally not exceed 97%.
FHA Loans
Backed by the Federal Housing Administration, these loans cater to first-time homebuyers and those with lower credit scores. The FHA offers loans with more lenient requirements, including lower down payment options. For FHA loans, the maximum LTV ratio is 96.5%, allowing borrowers to make a down payment of as little as 3.5%. The CLTV ratio for FHA loans, including junior liens, should not exceed 97.75%.
VA Loans
Designed for veterans and active-duty service members, VA loans are guaranteed by the Department of Veterans Affairs. Remarkably, they often allow for a 0% down payment (100% LTV), making homeownership more accessible. VA loans don’t have a strict CLTV limit. However, lenders may consider the homebuyer’s existing debt and remaining entitlement (unused VA loan benefit) when determining eligibility.
USDA Loans
Facilitated by the U.S. Department of Agriculture, these loans target rural property purchases. They also offer a 0% down payment option (100% LTV) for eligible borrowers in designated areas. Similar to VA loans, USDA loans do not have a hard CLTV limit. However, lenders will assess the homebuyer’s overall financial picture to ensure affordability.
Non-QM Loans
These non-conforming loans cater to borrowers who don’t meet the stringent requirements of Conventional loans. LTV requirements for Non-QM loans can vary significantly depending on the lender, loan program, and borrower profile. They may allow for higher LTVs (up to 90%) but often come with steeper interest rates and stricter qualification criteria. CLTV requirements for Non-QM loans are also highly variable. Some lenders may offer CLTVs exceeding 80%, while others may impose stricter limits.
Refinance vs. New Purchase Loans
It’s also important to understand that these ratios may be different when refinancing compared to new purchase loans. When buying a new home, the LTV and CLTV limits are typically stricter. This means your client will need a larger down payment and have less room to borrow against the property’s value. Lenders are more cautious with new purchases because they haven’t established a history with this homebuyer or the property. When refinancing the existing mortgage, the LTV and CLTV limits may be looser. This allows your client to potentially borrow more money based on the current value of their home and the amount they’ve already paid off on the original loan. Since they already own the property and have a payment history, lenders are generally more comfortable with a higher risk of this borrower defaulting.
Ways to Improve LTV and CLTV Ratios
As we’ve mentioned before, the ability to improve your client’s LTV and CLTV ratios, ultimately making their loan application shine and securing favorable loan terms, is partly in your hands. So how do you do it? Here are some practical strategies.
Increasing the Down Payment Size
The cornerstone of a healthy LTV is a substantial down payment. The more your client brings upfront, the smaller the loan they need, resulting in a lower LTV. Guide them on budgeting strategies and explore options to maximize their down payment. Consider discussing creative solutions like dipping into savings accounts, receiving down payment assistance programs, or even exploring the possibility of selling unwanted assets.
Paying Down Existing Loans
Existing loans, especially high-interest ones, can inflate the CLTV. Advise your clients to tackle these debts head-on. Prioritize paying down credit cards and personal loans to free up their credit utilization ratio and reduce overall debt. Educate them about options such as debt consolidation loans with lower interest rates that allow clients to put more toward their mortgage payments.
Enhancing Property Value Through Home Improvements
An often-overlooked strategy is making home improvements to enhance the property’s value. Renovations that increase the home’s worth can lead to a lower LTV and CLTV ratio since the loan amount is relative to the property’s appraised value. Whether it’s upgrading the kitchen, adding energy-efficient features, or improving curb appeal, these enhancements can positively impact the property’s value, ultimately benefiting your clients’ loan ratios.
Practical Advice for Brokers Guiding Clients on LTV and CLTV Improvement
Beyond suggesting these strategies, your expert guidance is paramount. Here’s how you can effectively lead your clients to LTV and CLTV success:
- Clearly explain the importance of LTV and CLTV in the mortgage lending process. Take the time to educate your clients about the impact of LTV and CLTV ratios on loan approval, interest rates, and mortgage insurance requirements.
- Offer personalized financial counseling to help your clients assess their current financial situation and identify areas where they can make adjustments to improve their LTV and CLTV ratios. Tailor your recommendations. A young couple with limited savings may benefit more from down payment assistance programs, while someone with high-interest debt may require debt consolidation strategies.
- Keep communication open and consistent. Regularly update clients on their progress and guide them through any challenges they face in improving their LTV and CLTV.
- Become a valuable resource beyond financial advice. Connect your clients with reputable contractors for home improvements or research down payment assistance programs in their area.
Risks Associated with High LTV and CLTV Ratios
While high ratios may seem attractive to homebuyers for lower down payments, they come with some potential drawbacks and risks for both lenders and borrowers.
One of the primary risks associated with high LTV and CLTV ratios is the increased likelihood of default for lenders. When borrowers have minimal equity in their homes due to high loan-to-value ratios, they are more vulnerable to financial hardship and market fluctuations. In the event of a downturn in the housing market or unexpected financial challenges, borrowers with high LTV and CLTV ratios may struggle to meet their mortgage obligations, resulting in an increased risk of default for lenders.
In addition, high LTV and CLTV ratios often result in higher interest rates for borrowers. Lenders mitigate the increased risk associated with these ratios by charging higher interest rates, which translates into greater long-term costs for borrowers. What’s more, borrowers with LTV ratios above 80% may be required to pay private mortgage insurance to protect the lender in case of default. This additional expense further adds to the overall financial burden of the borrower.
On top of that, borrowers with high LTV and CLTV ratios may be less likely to be approved for a loan or refinance. As they are considered higher-risk borrowers, lenders are more cautious when extending credit to individuals with minimal equity in their homes. This can make it challenging for borrowers to secure favorable loan terms or refinance existing mortgages, limiting their ability to take advantage of potentially more favorable market conditions or reduce their financial burden through refinancing.
Conclusion
Overall, LTV and CLTV ratios offer valuable insights into a property’s value and a borrower’s financial commitment, influencing critical aspects like loan approval, interest rates, and insurance requirements.
For borrowers, understanding these ratios means informed decision-making. They can approach the mortgage process with a realistic view of their financial situation and the impact of different loan options. By striving for a healthy LTV and CLTV, borrowers can obtain a mortgage loan that meets their financial goals and long-term stability.
For brokers, capitalizing on this knowledge means opening up a wider range of lending opportunities for clients. By helping clients improve their LTV and CLTV ratios, brokers can offer them more favorable loan terms and potentially significant savings in the long run.
Partnering with a knowledgeable mortgage lender like A&D Mortgage reinforces this approach. Don’t hesitate to take the first step toward achieving your business goals. Reach out to our expert team at A&D Mortgage today to discuss your clients’ unique loan requirements and open up a world of financial possibilities!
