By: Ask Bill
Submitted: 2010-12-13 04:16:21 | Word Count: 691
Explaining loan to value definition (LTV) can be somewhat tricky. After all not a lot of people may be able to grasp the concept and meaning of many financial terms. My Aunt Ginny, however, seems to be able to fully comprehend various terms and concepts of the world of finance even if she is just a full time housewife whose passion includes gardening and knitting sweaters for her nephews and nieces. What amazes me even more is her ability to explain it to people in everyday examples and simple references that makes finance less foreign and intimidating. But I suppose I should not find it surprising that Aunt Ginny knows her finances well because she is one of the few people whom I know who possess an uncanny ability to manage their finances efficiently and successfully without any help from a financial advisor.
Many financial experts may explain the loan to value definition (LTV) as an equation that mortgagers use to assess the risk of lending money for a borrower to purchase a property. For example, if you are buying a home which values at $300,000 and you put a down payment of $50,000, your LTV may be calculated by using the figure of your mortgage loan which in this case would be $250,000 and then dividing it from the value of your home. The percentage you get is the LTV ratio. Generally it may be referred to as the ratio between the amount of money you owe and the value of your property. But even that may sound like gibberish to many people. Aunt Ginny explains it differently. She compares an LTV to a watermelon.
[ advertisement ]
Let’s say you have a whole watermelon in front of you. The whole watermelon is the value of your home. Cut a section of the watermelon and give it to your creditor. That is your down payment. The balance you have is the loan you are taking from your creditor to purchase your home. The bigger the portion you give to your creditor the lesser the portion you have to take with you. The lesser the portion you keep the better. Isn’t Aunt Ginny simply wonderful? Basically, the bigger the down payment, the lesser the amount of mortgage that you may have to apply for. Lenders prefer giving out home loans with lower LTV ratio. This is because low LTV mortgages pose fewer risks than high LTV mortgages. You may be able to enjoy lower interest rates if the LTV ration of your loan is low.
Now assuming you have no choice but to give a very small portion of the whole watermelon to your mortgager you may have to be prepared to pay a higher interest rate on your mortgage. This is because the loan amount you take is bigger and your down payment is low. Generally the rule of thumb is to pay at least a 20% down payment but there may be mortgage lenders who might grant mortgage loans with down payments lower than 20%. In some cases you may not even be required to put any down payment at all. Of course the consequences may be, again, a significantly higher interest rate. Many lenders may also require private mortgage insurance premiums (PMI) if your down payment is less than 20%. Depending on the insurance company and the lender, your PMI may end up being as much as 1% of the loan amount.
In terms of market value, you may also benefit more with less watermelon in your hands. Property prices fluctuate and if they fall, if you have more watermelon with you your lender may no longer have enough collateral on your home to ensure that their investment is protected. You may also lose out on building enough equity on your home to ensure that you would profit from it if you decide to sell it. So when it comes to LTV ratios you might want to listen to Aunt Ginny and give as much portion of the watermelon to your mortgager as possible before taking the balance home with you.
