The loan to value ratio (LTV) is one of the metrics that lenders will use in order to determine your risk profile for home loans. The better that you do with this metric, the better deal you will get on a loan. However, people often make mistakes when they are trying to manipulate a better LTV for themselves. Here are seven mistakes that you should avoid when you begin trying to improve your finances.
1. What is the LTV ratio?
Your LTV ratio is a term expressing the amount of money that is still on the mortgage lien as a percentage of the total home value. For instance, if a home has been appraised at $200,000 and there is still $100,000 that has not been paid off, the LTV ratio is 50 percent.
You lower the LTV as you pay down the lien on the property. In the above example, if the borrower pays off $50,000 of the $100,000 that is left on the loan and the home maintains its $200,000 value, the LTV ratio becomes 25 percent.
Many people mistakenly believe that the LTV ratio does not change, when, in fact, it does change as the loan is paid down.
2. Is a lower LTV ratio worse for the borrower?
A lower LTV ratio is actually what you want as a borrower. The lower that ratio is, the more ownership you have in the property. More ownership opens up your options for home equity loans and may lower your fees and interest rates on the property.
3. Do prepayment penalties mean that you should keep your LTV ratio high?
Many lenders will actually try to deter borrowers from paying down a loan early through a penalty for early payments. If you have yet to sign a mortgage contract, be sure that you are not signing to a prepayment penalty if you can help it. However, even contracts with a prepayment penalty may be worth paying off, because the interest that would be implemented into the lien balance far outweighs the lump sum cash payment of the penalty.
Do not make the mistake of thinking that you need to pay off your loan more slowly just because you see a cash penalty on the contract.
4. Isn’t a lower LTV ratio better because I do not pay as much cash upfront?
The pricing adjustment tiers that are set up based upon your LTV ratio increase as the ratio increases. You may have more cash in your pocket, but unless you are outstripping the difference in the interest rate, you will end up losing that cash over the long run.
It is possible that holding cash for other investments may be a better strategy for you than paying down your LTV; however, you have to find an investment that is quite good to do so. Interest rates from banks are difficult to overcome unless you are taking on even more risk in the market, and you will never outpace them using a fixed rate investment. It is usually a better idea to pay down the loan as much as possible, effectively paying yourself back the interest rate that you are no longer responsible for. Future monies that you earn and invest will then appreciate on your behalf without the weight of a home loan interest rate paying hanging around your financial neck.
5. Should I go below the 80 percent threshold with a government sponsored entity (GSE)?
Many GSE programs such as Fannie Mae or the Federal Housing Administration (FHA) will administer loans or insurance programs that do not require the 20 percent down payment of most conventional loans. Paying this 20 percent places you right at the 80 percent threshold that most real estate investors say that a borrower should never duck below. However, the 80 percent threshold is more important than you may think.
You will not be able to utilize much, if any, of the equity that you have in a property if you are below the 80 percent threshold; most lenders will not allow you to borrow any more than 85 percent of home value. You will also be unable to use combo mortgages in order to keep your LTV ratio below other key levels with two separate payments, meaning that you are basically naked in the market. If something unexpected happens such as a medical emergency or a job loss, you are at the complete mercy of your lender.
6. Should I bail on an underwater property?
Many people left properties in the wake of the 2008 housing crisis. The ethical argument aside, many of these borrowers may have actually made a wise financial choice. However, there are more programs in place to help people who have lost equity in their homes. The Home Affordable Refinance Program now offers LTV ratios up to 125 percent, meaning that you can borrow 25 percent more than the value of the home, as long as you have a loan administrated by Fannie Mae or Freddie Mac. Other programs have modified mortgage payments that make abandonment look less attractive.
7. Should I wait on home values to increase to increase my LTV?
Trying to increase a term or put off payment in order to wait for the market to increase the home value is a bad strategy unless you are very experienced in real estate. Simply pay down the loan!
2 Point Highlight
However, even contracts with a prepayment penalty may be worth paying off, because the interest that would be implemented into the lien balance far outweighs the lump sum cash payment of the penalty.
Many GSE programs such as Fannie Mae or the Federal Housing Administration (FHA) will administer loans or insurance programs that do not require the 20 percent down payment of most conventional loans.
