Understanding the Loan to Value Ratio

These days many renters are taking advantage of the present low level of interest rates to get into a home of their own. In addition, many current homeowners are taking advantage of those same low interest rates to refinance their home mortgage loans at more favorable interest rates.

Therefore, whether you are a current renter moving into a home of your own or a long time homeowner seeking a lower interest rate, it is important to understand one of the most important financial formulas - the loan to value ratio.

The easiest way to understand the loan to value ratio is that it represents the relationship between the amount of the outstanding mortgage as compared to the current value of the home. Since housing prices have been rising very fast in many areas of the country, many current homeowners have built up quite a bit of equity in their homes.

Many homeowners, for instance, find themselves in the happy circumstance of owning a home that is worth substantially more than they paid for it, or substantially more than they owe on it. This means that the homeowner has equity that can be used to borrow additional funds, refinance the mortgage or even shorten the term of the mortgage loan.

It is fairly easy to calculate the loan to mortgage ratio. It simply requires knowing approximately how much your home is worth, the amount of the outstanding mortgage and the amount of the original down payment. For our exercise we will use a home value of $150,000. The approximate value of your home can be estimated by looking at what similar homes in your neighborhood have sold for.

When calculating the loan to value ratio, the first step is to take the original purchase price of the home, in this case $150,000 and subtract out the amount of the original down payment. For this exercise we will use a down payment of $20,000.

The loan to value ratio is calculated by subtracting the $20,000 down payment from the purchase price of $150,000. In this case the resulting number is $130,000, which represents the $150,000 purchase price minus the $20,000 down payment. Dividing the $130,000 loan amount by the $150,000 purchase price gives us a loan to value ratio of 0.87, or 87%.

It is important to know your loan to value ratio, since this number will be important to lenders any time you apply for a loan.

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