Loan to value ratio (LTV) is a concept that describes the relationship between a loan and the value of an asset purchased with the loan. It is mostly used by lenders to gauge their risk on loans. The higher the loan to value ratio, the riskier the loan for the lender.
Loan to value is an important factor used by lenders when assessing borrowers for a mortgage. Generally, when the equity in the loan is low, there is a higher likelihood that the lender will absorb the loss of the loan. Lenders, therefore, prefer borrowers who will have a personal stake in the asset they will be purchasing. The borrower’s stake in the asset will make it unlikely for the borrower to default the loan. Moreover, if the borrower defaults, the lender can always sell the asset and recoup their loan money and interest.
If the loan to value ratio is very high, banks usually insist that the borrower buy private mortgage insurance for the asset, which will protect the lender from the borrower’s default, making the asset more expensive.
Loan to Value Formula
This metric is key to determining the risk level of a loan to a lender. The loan to value ratio shows how much of the value of an asset is been financed by the lending institution.
So, using a mortgage as an example. The loan amount would be the total mortgage amount, and the price of the asset is the appraised value of the property being mortgaged.
The higher the value of the loan compared to the value of the asset, the stricter the lender will make the lending criteria. This means that the lender is taking a high risk and will want to guarantee that the borrower will not default, or, should the borrower default, there is a cushion for the lender to recover his money.
Low loan to value ratios, typically below 80%, carry lower rates since they are low risk. Banks also consider high-risk borrowers with loan to value ratios above 80% but with a higher rate. Other factors that group borrowers as high risk include low credit scores, previous late payments in their mortgage history, high debt-to-income ratios, high loan amounts or cash-out requirements, insufficient reserves and/or no income. Only borrowers with higher credit scores and satisfactory mortgage history are allowed a higher loan to value.
A loan to value of 100% is rarely accepted and is reserved for the most creditworthy borrowers. Applicants with a loan to value ratio above 100% are rejected, and if any is granted, the loan is called an underwater mortgage.
Loan to Value Example
Mr John wants to buy a new house and has applied for a mortgage at a bank. The bank needs to perform its risk analysis by determining the loan to value of the loan. An appraiser of the new house shows that the house is worth $300,000 and Mr John has agreed to make a down payment of $50,000 for the new house. What is the loan to value ratio?
- Loan amount: $300,000 – $50,000 = $250,000
- Value of asset: $300,000
Using our formula we can substitute the values for the variables in the equation:
For this example, the loan to value amount is 0.83333. However, you would express the ratio in percentage by multiplying by 100. So the loan to value amount would be 83.33%. The loan to value ratio is above 80%, so analysts would consider it high.
Consider another scenario where the owner of the new house Mr John wants to buy is willing to sell the house at a price lower than the appraised value, say $280,000. This means that if Mr John still makes his down payment of $50,000, he will need only $230,000 to purchase the house. So his mortgage loan will now be $230,000.
Let us calculate the loan to value of the new loan application.
- Loan amount = $230,000
- Value of house = $300,000
The Loan to value amount would be 0.7667. Converting the loan to value to percentage would be 76.67%. The loan to value ratio is less than 80% so it is low-risk for the mortgage bank. Note that the loan to value formula used the appraised value of the house and not the selling price.
Loan to Value Analysis
Loan to value is an important metric that categorizes borrowers. Though it is not the only metric that determines high-risk borrowers, it indicates how risky a loan is, and how the borrower will be motivated to settle the loan. It also determines how much borrowing will cost the borrower. The higher the loan to value ratio, the more expensive the loan.
Key factors that affect the loan to value ratio is the equity contribution of the borrower, the selling price and the appraised value. If the appraised value is high, that means a large denominator and hence a lower loan to value ratio. It can also be reduced by increasing the equity contribution of the borrower and reducing the selling price.
A major advantage of loan to value is that it gives a lender a measure of the level of exposure to risk he will have in granting a loan. The limitation of loan to value is that it considers only the primary mortgage that the owner owes, and not including other obligations like a second mortgage. A combined loan to value is more comprehensive in determining the likelihood of a borrower settling the loan.
Loan to Value Conclusion
- Loan to value is a measure of exposure to risk a lender will bear on a loan.
- This formula requires two variables: loan amount and value of asset.
- The higher the loan to value, the riskier the loan to the lender.
- Loan to value is limited to only the primary mortgage that the owner owes.
Loan to Value Calculator
You can use the loan to value calculator below to quickly calculate loan to value by entering the required numbers.
FAQs
1. What is the loan-to-value (LTV) ratio?
The loan-to-value (LTV) ratio is a concept that describes the relationship between a loan and the value of the associated asset. It is mostly used by lenders to gauge their risk on loans. The higher the loan to value ratio, the riskier the loan for the lender.
2. What is the formula for calculating the loan-to value (LTV) ratio?
The formula for calculating the loan-to-value ratio is as follows:
Loan to value = Loan amount / Price of asset
3. What is a good and a bad loan to value (LTV) ratio?
A good loan to value ratio is anything below 80%. This means that the risk of the lender is low. Conversely, anything above 80% is considered a bad loan to value ratio as it is riskier for the lender.
4. How can you improve your loan-to-value (LTV) ratio?
There are a few ways in which you can improve your loan-to-value ratio.
1) Increase the equity contribution of the borrower
2) Sell the asset for a price that is lower than the appraised value
3) Reduce the size of the loan amount
5. How does loan to value (LTV) ratio affect interest rates?
In general, the lower the loan to value ratio, the lower the interest rates. This is because the lender is taking on less risk and is thus willing to offer a lower interest rate. Conversely, a high loan to value ratio will lead to a higher interest rate as the lender is more at risk of not getting their money back.
