Loan-to-Value Ratio
Represents the percentage of a property's appraised value or purchase price that is being financed by the loan
What Is the Loan-to-Value (LTV) Ratio?
Loan-to-Value Ratio (LTV Ratio) is a financial metric used by lenders to assess the risk of a loan. It represents the percentage of a property's appraised value or purchase price that is being financed by the loan.
The ratio tends to be higher for assets more desirable as collateral. The stability of the asset's value, its liquidity in the market, and several other factors determine the asset's desirability.
High ratios tend to be riskier. Therefore the loan has a higher interest rate if approved, that is, high risk being compensated by a higher return by the borrower to the lender. Moreover, high-risk loans sometimes mandate the borrower to purchase private mortgage insurance to offset the lender's risk of non-repayment.
Key Takeaways
- Loan-to-Value Ratio (LTV) measures the relationship between the desired loan amount and the appraised value of the collateral asset.
- Higher LTV ratios indicate riskier loans, resulting in higher interest rates for borrowers.
- Lower LTV ratios indicate a higher equity stake in the asset and lower risk for loan repayment.
- Private mortgage insurance may be required for high-risk loans to offset the lender's risk of non-repayment.
How is LTV Calculated?
The formula for calculating the ratio is as follows:
Loan To Value % = (Loan Amount / Collateral Value) * 100
An LTV ratio is obtained when the borrowed amount is divided by the collateral's appraised value, which is then expressed as a percentage.
For example:
- X buys a home valued at $10,000
- X makes a down payment of $2,000
- X borrows $8,000
X's Loan to Value % = ($8,000 / $10,000) * 100 = 80%
Therefore, the loan to value ratio on X's home is 80%. Or, 80% of X's home value is debt.
These ratios are vital for lenders to decide whether the borrower has the credit profile to repay the loan. It is generally used when loans are taken to buy a home, refinance an existing loan, etc.
This ratio is part of a bigger picture that includes:
- The credit score of the borrower
- Income that is available to make monthly payments, i.e., the ability of the borrower to repay
- The purchased asset also affects the loan approval chances due to the probability of the asset's value going down.
If the borrower has a good credit rating, it will be easier for them to get loans with a high LTV ratio as the lender is confident in the borrower's ability to repay the loan. In addition, the debt-to-income ratio also acts as an indicator of the ability of the borrower to make repayments.
Debt-to-income ratio helps the lender assess the borrower's ability to service their outstanding loans.
What are the five C's of Credit?
These are the five major forces that determine the creditworthiness of a borrower. The five credit C's provide creditors with a framework for assessing a loan applicant's eligibility for a new loan and checking their creditworthiness.
Let's briefly understand these 5 C's.
1. Credit History
The approval of different loans depends on the borrower's credit history - his previous payments and how well he managed his loan during the loan tenure.
A credit report is a document enlisting your credit history, containing details about other loans and payment history.
The credit report provides details about the previous and existing lenders for the borrower, payment history, types of loans taken, etc.
2. Capacity
Lenders would generally look for your employment history and current income to determine your ability to make monthly payments comfortably. Other factors to consider are the amount of income and stability of income.
The debt-to-income ratio has to be evaluated for a borrower, including the current debt. Also, the income taken in the calculation is generally pre-tax due to the government's tax benefits on certain types of loans.
3. Collateral
There are 2 types of loans:
- Secured
- Unsecured.
A vehicle or a home loan is generally secured, i.e., the borrower has to pledge something as collateral to obtain the loan.
Any current debt obligations the collateral has secured will be deducted from the collateral's value to calculate the LTV ratio.
The value left will decide whether the loan is approved or not. Also, if the borrower cannot repay a secured loan, the lender will seize the collateral's ownership.
4. Capital
Here, capital refers to the total of investments, savings, and other assets that can be secondary sources of repayment in case the borrower suffers any significant loss in a business due to some contingent event or the person loses their job.
5. Conditions
Generally, lenders would prefer to know the purpose for which the money is being borrowed, for example, whether the loan will be used for marriage-related expenses, buying a home, or some other asset.
They also check whether the loan amount has been used for the purpose for which the loan was issued. Lenders also take into account economic and environmental conditions.
Loan-To-Value Ratios Variations
We can classify some of the variations of loan-to-value ratios into three different categories, which are described below:
1. FHA Loans
The loans which are received by the homeowners directly from the Federal Housing Authority are called FHA loans.
These loans have been designed to encourage home ownership in the country for people who cannot make a sizeable down payment on a standard loan.
The borrower has to make at least a down payment of 3.5% of the collateral value under FHA loans. It is compulsory to buy mortgage insurance so that the borrowers don’t save money by making huge payments upfront.
2. VA Loans
These loans are government-sponsored mortgages for US military personnel and veterans. Under this type of loan, the borrowers can borrow 100% of a home’s value.
However, the borrowers have to pay any fees and other costs at closing together with the purchase price exceeding the value of a home.
3. USDA Loans
The US Department of Agriculture provides these loans to individuals living in rural areas to afford ownership. The government backs these loans.
The total purchase price of an existing home can be financed through a USDA loan scheme. The USDA will often even cover “excess expenses” (those that exceed the home’s value) for loans on existing homes, including:
- Appraisal fee
- Tax service fee
- Homeownership education fee (a class people have to attend to qualify for a USDA loan)
- The initial contribution to the escrow
USDA loans for building homes can have a maximum of 90% to 95% LTV ratio. However, expenses other than the loan are not financed.
Why Do LTVs Matter?
This ratio is a good indicator of the risk a company has to take in lending money to a particular customer. The ratio is on the higher side when the loan amount that the borrower desires is very close to the value of the collateral provided by the borrower.
Here’s how the ratio impacts the borrowers and financial institutions:
1. Higher Interest Rate
The rate of interest offered on home loans plays a crucial role in a borrower's ability to decide how much they should pay in installments according to their income.
The higher the ratio, the higher would be the interest rate. This is because a higher ratio is considered to be relatively risky.
Therefore, the lower the ratio, the lesser the monthly installments (EMI), and the lower the effect on your household budget over the loan period.
Therefore, the borrower should always look to make as high a down payment as they can make to save interest on the extra down payment, which, when compounded, makes a massive difference in the amount paid to the organization as interest.
However, people who can’t afford a larger down payment are advised to save more in the future to make a larger down payment.
2. Higher LTV = Home Loan Insurance
A higher loan amount relative to the collateral value affects the cost of other products and services. A high loan-to-value ratio would also be an added cost to your home insurance.
Generally, the annual premium of the added insurance is 1%. However, the cost depends on several factors; for example, let’s say you add an insurance premium to your monthly installments; this feature forces you to pay higher EMIs.
Insurance is the guarantee to the lender as well as the borrower that the payment will be made eventually. For example, during the 2008 crisis, many people defaulted on their home loans which led to the crisis; such events were beyond anyone’s control.
People who can afford to pay a more significant chunk of the loan as a down payment should always go for it as it saves them interest and home insurance, thus reducing the effective cost of the loan for the borrower.
3. Home Loan Approval
Gross monthly income, loan tenure, existing monthly obligations, and LTV ratios are the factors lenders generally look for in a borrower before lending out the money and checking the borrower's eligibility. The lender evaluates the risk profile by these factors.
The riskier a loan is evaluated, the reduced chances of it being approved. For example, when borrowers make a substantial down payment, they are considered people with a good credit rating as the risk of loss is deficient in the case of these borrowers.
For example, if you’ve put $30,000 down on a home appraised for $100,000, your LTV on a $70,000 loan will be 70%. So, the smaller your down payment, the larger your loan-to-value ratio.
4. Home Loan Refinancing
Since land prices are expected to go up in the long term, the home's value might get appraised during the tenure. When this happens, the borrower can refinance his borrowed money.
Refinancing is getting a loan from other lenders at a cheaper interest rate than the existing one.
By refinancing, the borrower benefits from lower interest rates, therefore, lower payments or a top-up on the original amount.
When a borrower is refinancing a loan, the ratio is lower as the home value has been appraised, thus allowing the borrower to bargain with the lender for a lower interest. An LTV of 75% or lower is considered pretty good.
5. Build Your Home Equity
Home equity is the portion of your property you actually “own.” The amount of the down payment determines your equity in the property as against the lenders.
One of the most critical factors for a borrower is his stake in the home which can be used for different reasons. First, the borrower’s equity increases in the house as more installments are paid off.
As said, someone with less ownership is more likely to fall behind on payments seeing that they have a lower equity stake.
The LTV plays a significant role in deciding the ownership of your asset. A lower LTV ratio indicates that you have a high right of the asset.
However, if you pay a smaller down payment, it indicates low equity in your home.
Loan-to-Value Ratio FAQs
A 70% LTV translates to “0.7,” which means the borrower has to contribute only 30% of the money from his savings. The other 70% is loaned out to him by the financial corporation to finance the property.
If you have an LTV of 80% or lower, you can bargain with the bank for lower rates and more favorable loan covenants. This ratio can be reduced drastically by making a larger down payment or consulting with your financial advisor to minimize the amount you pay to the lender.
By dividing the loan amount by the appraised value of the collateral, we obtain the loan-to-value ratio, which is generally expressed as a percentage. For example, if you buy a home valued at $90,000 for its appraised value and make a $15,000 down payment, you will borrow $75,000.
If closing costs are included in a loan, it can keep your up-front costs lower, but also increases the loan-to-value ratio: LTV = Loan amount / Collateral value or $50,000 loan / $80,000 collateral value = . 625 or 62.5%.
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