Lenders use loan to value (LTV) ratio to assess an applicant's risk level. The loan becomes riskier the higher the loan to value ratio -- or the lower the down payment -- and this usually means a higher interest rate or other costs for the borrower.
Loan to value is the loan amount compared to the property value. Your lender will divide your loan amount by the appraised value or purchase price of the property (which is lower) to determine your LTV ratio. This means a home worth $400,000 with a $300,000 mortgage has a 75% loan to value.
The loan to value ratio is important to mortgage lenders for several reasons. The down payment you provide impacts the LTV. If you have a down payment of less than 20% and an LTV of more than 80%, a conventional loan will require private mortgage insurance. Mortgage insurance is another expense that will be added to your mortgage payment, and it can be as low as 0.22% to as high as 1% of your loan as an annual expense.
If you must pay PMI on your loan, it can be dropped off as soon as your loan reaches 80% loan to value, either through increasing home values or paying down your loan.
If you want to refinance your mortgage down the road, your LTV will come into play again. The appraised value of your home is determined based on comparable sales over 3 months. If you have a high LTV, it may mean a higher interest rate on your new loan, as you are considered higher risk. In general, an LTV of more than 70% results in a rate increase of 0.125% for every 5% LTV.
The lower your LTV, the more likely you are to be approved for a loan and the better your rate. By far, the easiest way to lower your LTV is through a larger down payment. This will give you automatic equity and vested interest to help you secure a lower interest rate on your mortgage.
Remember that lenders consider other factors with your LTV ratio including employment, down payment, debt-to-income ratio, credit score and income.