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If you’re looking to take out a mortgage, a home equity loan, or home equity line of credit, you’ve probably heard a lot of terms being thrown around, including loan-to-value ratio. While this term may sound complex, it really couldn’t be more simple. That’s why we’ve taken it upon ourselves to explain the meaning once and for all. Keep reading to learn what a loan-to-value ratio is, how it works, and how you can use yours to your advantage.
What is a loan-to-value ratio?
A loan-to-value ratio is the measure of the size of any loans you’ve taken out on your home in comparison to the current value of your home.
For example, if your home is worth $200,000 and you have $100,000 left to pay on your mortgage and you want to take out a $50,000 home equity loan on the property, your loan-to-value equation would look a little something like this:
($100,000 + $50,000)/$200,000 = 0.75 or $150,000/200,000 =0.75
In this case, you would have a 75% loan-to-value ratio.
How loan-to-value ratios are used
Loan-to-value ratios are used by lenders to evaluate the risk in lending to you. You usually see them used in scenarios where the loan is secured by the home, meaning mortgages, home equity loans, or home equity lines of credit. Typically, lenders will only approve you for a loan that’s worth 85% or less of the home’s total value.
Conventional wisdom states that the higher your loan-to-value, the greater risk you are to the lender. Lenders prefer that you have some stake in the property – either from your down payment or making mortgage payments – so that you’re more likely to protect your investment, even if times get tough.
In the event that you do stop making payments, however, capping their lending at less than the full value of the home means that, if they foreclose on you, they’ll be able to sell the property for less than it’s worth and still recoup their investment.
Ways to improve your loan-to-value ratio
If you’re looking to get a loan, but your loan-to-value ratio is too high to be approved, don’t worry. There are some things that you can do to change the numbers. They are as follows:
Pay down your loan(s)
One of the first things you can do to change the ratio is to work to pay down any existing mortgages, loans, or lines of credit that you currently have against the property. As the amount you owe goes down, as long as property values stay the same, so will your ratio.
Wait for property values to rise
This one is tricky. Another way to improve your loan-to-value ratio is to wait for appreciation to occur. Usually, this happens slowly and over time. However, if you’re lucky enough to have bought at the right time in an up-and-coming neighborhood, property values may be rising more quickly than you think.
If you have questions regarding what your home is currently worth, we suggest having a professional appraisal done. That’s the surest way to pinpoint a home’s current value.
Make smart home improvements
Making smart home improvements is another way to raise property values – without having to wait for the ground to appreciate first. If you decide to go this route, though, be sure to do your homework and pick the home improvement projects that have the best return on investment.