Unpacking the LTV ratio: Why getting a home loan is a calculated risk

Let's be real: Lending money is risky business.

Whether you're bailing your buddy out of a bind or helping relatives recover from an unexpected expense, entrusting people with your hard-earned cash means taking a gamble on whether you'll ever get it back in full and on time.

But mortgage lenders don't like to gamble, and they don't trust easily. That's why they use a little metric called the LTV (loan-to-value) ratio to determine just how much risk they're taking on when they lend money to finance a home.

You may be saying, "I just want a house; why should I care about an LTV ratio?" Relax, we're about to tell you:

So, what's LTV exactly?

Put simply, it's the way lenders assess how much skin you have in the game if they finance your new house. It also helps the lender know if you could end up owing more than your house is even worth.

Underwriters, the people who scrutinize your loan file, use LTV ratios (along with your credit score, income and other items) to decide whether you're qualified to receive a mortgage.

How is it calculated?

In the most rigid way possible: Math.

The underwriter divides the amount of the loan you want with the appraised value of the property. This gives the lender a measurement — usually calculated as a percentage — to determine the risk present in financing your property.

Simple math tells us if you pay 20 percent of the purchase price as a cash down payment and the mortgage company is financing the remaining 80 percent, you've got an 80 percent LTV ratio.

How do I factor in?

Since most homes sell at a price close to the appraised value, your down payment is the best tool to lower your LTV. The more money you commit to putting down on your house, the lower your LTV ratio.

That's a good sign for lenders because it means you're less likely to default on your loan since you've invested your own money in the property. That's also good for you because it means you may get competitive interest rates and a cheaper mortgage, says Kris Sechrest, one of Movement's senior underwriters.

But what if you want a loan with an amount at or near the property's value? You'll likely have a high LTV ratio, which tells the lender there's greater chance of you defaulting because you have less skin in the game (i.e. more of their money on the line and not enough of yours).

A high LTV — generally above 80 percent — may yield a pricier mortgage, along with higher interest rates and private mortgage insurance (PMI).

Can I change my LTV ratio?

Over time, yes.

Remember, the LTV ratio depends on your home's value and your loan amount. If those two things change, so will your LTV.

As time passes and your property value goes up, your LTV ratio goes down. If the loan amount changes (i.e. you pay down your mortgage balance every month), then the ratio drops because you owe less money.

This is cause to celebrate if you're paying PMI.

Once your ratio falls below 80 percent, you may be able to  refinance your loan and ask your lender to cancel PMI, possibly saving you hundreds to thousands of dollars a year.

Are there exceptions?

Of course. If you're buying a second home or investment property, lenders want you to put more money down to mitigate their own risk, Sechrest says.

Translated, they want to see a lower LTV ratio for those kinds of loans because secondary properties are, well, secondary.

"If something happens in your life, a job situation, a family situation, medical…most folks are going to take care of their primary residence first so they have a place to live," he says.

That leaves the lender on the hook for any unpaid costs on your cozy vacation home if it goes into foreclosure and won't sell.

I want to learn more…

And we'd like to help you. Talk to a mortgage professional who can help you navigate the loan process and answer all your questions.