Finance

Loan-to-Value Ratio

Loan-to-Value Ratio

In many instances, the home loan borrowers need to fulfill many requirements defined by the lenders, primarily in relation to their yearly income, the minimum payment for which a creditor must be eligible for a residential mortgage, an excellent credit score, etc. One of the significant conditions for home loans, however, is the maximum loan-to-value ratio (LTV). The Loan-to-Value ratio is often used ratio in mortgage lending to determine the lending risk that financial institutions and other lenders examine before approving it. Lenders assess the LTV ratio to determine the level of exposure to risk they take when underwriting a mortgage.

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What is the Loan-to-Value Ratio (LTV Ratio)?

A Loan-to-Value ratio is a ratio that compares the amount of loan one is hoping to borrow against the appraised value of the property he/she wants to buy. Lenders use this ratio to determine how risky a loan is, whether mortgage insurance will be required, and whether to approve or deny the loan. Loan-to-Value ratio and risk are directly related as a higher LTV ratio suggests more risk because of a higher chance of default. This ratio is used for several types of loans, such as Home Loans, Auto Loans, and for purchases and refinances. The value of an asset is generally determined either by independent appraisers or the most recent purchase price of an asset. When both values are known, the lender will choose the lesser of two values. In short, the Loan-to-Value ratio shows how much of property one truly owns compared to how much he/she owes on the loan taken out to purchase it. LTV essentially provides the borrower with the maximum percentage of the value of the pledged collateral that he can borrow.

How Loan-to-Value Ratio is calculated?

The Loan-to-Value ratio is calculated by dividing the amount borrowed by the appraised value of the property. To calculate the Loan-to-Value ratio, the following formula is used:

LTV Ratio = Mortgage Amount/Appraised Property Value

Example:

If person ‘A’ buys a home, which is appraised at Rs. 70,00,000 for appraised value and make a down payment of Rs. 10,00,000, then ‘A’ will borrow Rs. 60,00,000.

The LTV Ratio can be calculated as following:

LTV Ratio = Mortgage Amount/Appraised Property Value

LTV Ratio = 60,00,000/70,00,000

= 0.857

=85.71 %

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Why is the LTV Ratio important?

  • The Loan-to-Value ratio indicates the level of risk associated with the Loan/Mortgage. The reason being is that the acquired mortgage property is used as collateral.
  • The LTV ratio is a significant tool that evaluates the loan risk that the lender bears by offering the loan as requested by the borrower.
  • It helps the lenders in determining borrower’s qualification for loans and rates.
  • It measures the relationship between the loan amount and the market value of the asset securing the loan.

Limitations of LTV Ratios:

  • To the borrower, a high loan-to-value ratio loan is likely to come with a high-interest rate.
  • Even if the principal is not more, common fees on both mortgages and loans such as closing costs, appraisal fees, and prepayment penalties, and other fees could raise the debt.
  • Loan-to-Value ratios are an implication rather than an exact science. There are no definitive criteria that tell someone that a loan would be approved if the LTV ratio exceeds a certain percentage.

Conclusion:

Loan approval, along with several factors such as credit history, debt-to-income ratio, also depends on Loan-to-Value Ratio. As the loan-to-value ratio is the percentage of property’s value that is dedicated to loan, it is one of the significant factors for both lender and borrower.

 

Author: Hetvi Shah

About the Author: Hetvi is a BBA(Finance) graduate. She is currently pursuing an MBA with Finance specialization. She has a keen interest in Financial Market, Financial Management, and Financial Analysis.

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