If you’re in the market for a mortgage, you’ve no doubt considered important factors such as your credit history and your ability to pay such a loan. But there’s another key ratio you need to be aware of, as it can have a huge impact on your mortgage approval, as well as your mortgage costs over the long run.
Loan-to-value, or LTV, is one of the first things a lender will assess when presented with your mortgage application. In this article, we’ll go over how LTV is calculated and how it works with a mortgage, and help you decide how much loan-to-value to shoot for when you purchase or refinance a home.
Loan-to-value is a key ratio used by lenders when they’re qualifying you for a mortgage. Put simply, it’s your mortgage loan amount expressed as a percentage of the appraised value of the home you’re buying.
How Do I Calculate Loan-to-Value?
To calculate the loan-to-value ratio when purchasing a property, simply divide the mortgage amount by the home purchase price, which should equal its appraised value. If you’re refinancing a mortgage on a home you already own, the loan to value would be the new mortgage amount divided by the appraised value of the home, or the value that the bank is willing to accept for the home.
Is It Better To Have A Lower Or Higher LTV?
Generally speaking, the lower the loan to value, the better. It means that the borrower is contributing more equity to the home purchase (or refinance). This lowers the risk for the lender and makes it easier for the mortgage to be approved. Not only that, but having a smaller mortgage lowers your lending costs, and in some cases may get you a better interest rate.
Just because your LTV is higher isn’t necessarily a bad thing. Because the payments can be stretched over as many as 30 years, and with mortgage interest rates currently at historical lows, an extra 5% down payment may not make that much difference and be better spent somewhere else. Of course, when it comes to figuring out what your ideal LTV will be, it’s always best to speak with a mortgage professional.
What Is The Maximum Loan To Value?
In Canada, you can purchase a home with as little as 5% down payment, resulting in a loan-to-value of 95%. In fact, once the default insurance is applied, your loan-to-value is closer to 98%. Mortgages with 5% down are very common, especially amongst first-time buyers. With the cost of living as high as it is, it’s not easy for young Canadians to save for a mortgage down payment, especially in expensive urban centres, like Toronto or Vancouver. CMHC refers to the default insurance, which is required with all mortgages with an LTV above 80%.
A Note About Default Insurance
Default insurance was introduced in Canada through the Canada Mortgage and Housing Corporation (CMHC) after the Second World War, as a way to help returning veterans find affordable housing. Since then, it’s mandate has been expanded to help all Canadians.
Default insurance doesn’t cover borrowers, rather it protects the lender in case the borrower stops making payments and defaults on the mortgage. If lenders didn’t have this protection, they would be much more reluctant to provide home loans to a large segment of the population. This is how default insurance helps to make housing more accessible, and the housing market more liquid.
In Canada, there are three companies that provide default insurance to mortgage lenders on high ratio mortgages – CMHC insures the vast majority of mortgages, with Genworth Canada and Canada Guaranty being key competitors.
In addition to high LTV standard mortgages, default insurance can also be required for mortgages on certain restricted properties, such as mobile homes, certain seasonal properties, and houses that don’t meet the lender’s conventional lending guidelines i.e. low square footage.
Conventional Mortgage LTV
If your down payment, or equity, is 20% or greater, your mortgage will be conventional. There are a few exceptions to this rule depending on your specific situation. Generally, however, this means that CMHC insurance won’t apply, so the default risk will not be shared with the lender.
For the borrower, the beauty of a conventional mortgage, with an LTV of 80% or less, is that you’re not on the hook for the costly CMHC premiums, which can be as high as 4% of the mortgage amount. Also, as stated, the lower the LTV, the lower your mortgage amount, which means reduced interest costs.
How Does Loan-To-Value Work With A Mortgage Refinance
We mentioned previously that when you purchase a home, your loan-to-value can be as high as 95% (5% down payment). This isn’t true of a mortgage refinance. A mortgage refinance occurs when you decide to borrow against the equity of a home you already own. In this case, your mortgage must remain conventional, and the LTV cannot exceed 80% after the new funds have been added. For this reason, CMHC is no longer in the business of insuring mortgage refinances.
As an example, let’s say that you’ve owned your home for 10 years. During that time, you’ve paid your mortgage balance down to $150,000. The home currently has an appraised value of $300,000. Your current LTV is 50% ($150,000/$300,000 = 50%). You want to borrow some additional funds to pay for a home renovation, as well as a second vehicle for the family.
The total cost of the vehicle and home improvements will be $70,000. This will bring your mortgage up to $220,000, for a total LTV of 73%. Because you are within the 80% threshold, you have room to refinance, purely from an LTV standpoint. In this case, the most money you could borrow would be $90,000, for a total mortgage of $240,000 or 80% LTV.
Other Factors For Mortgage Approval
Loan-to-value is not the only consideration when applying for a mortgage. There are other factors that you must consider before buying a home. Your credit score, annual income, employment history, source of down payment – all of these are things the lender will take into account when assessing your mortgage application.
What Loan-To-Value Should I Plan For?
We trust that you now have a sound knowledge of loan-to-value, how it’s calculated, and how it works when you’re getting a mortgage. But you may be wondering what percentage loan-to-value is optimal for your situation. Remember, everyone is different. If you can obtain enough resources to qualify for a conventional mortgage (80% LTV or lower), this would be recommended as it would save you from having to finance the costly CMHC premiums. For many Canadians, however, especially first-time home buyers, that’s not the reality. If the maximum LTV is more realistic, it’s not a bad thing. Over time, as you pay down the balance of your mortgage, and your home rises in value, your LTV will improve, which will provide you with more options in the future.
Tom Drake is an authority in Canadian personal finance. He is a financial analyst and has been writing about personal finance since 2009 at the award-winning MapleMoney. His work has appeared in MintLife, Canadian MoneySaver, and U.S. News & World Report, and has been quoted in The Globe and Mail, Yahoo Finance, and Financial Post.