Loan to Value Ratio (LTV)

What is Loan to Value Ratio?

Loan To Value Ratio is a ratio of the amount of loan with respect to the total value of a particular asset and is most commonly used by banks or lenders to determine the amount of loan already given on a specific asset or the margin that is to be maintained before issuing money to safeguard from flexibility in value.

Let’s take a simple example. Let’s say you want to purchase a home. And you want to take the help of a bank to take a certain amount of loan. Why? Because currently, you don’t have that much cash available to buy the home all by yourself. So you go to the bank, understand their LTV and decide to buy a home.

If we add some figures, it would become easy for us to understand. Suppose you want to buy a home worth the US \$200,000 (the appraised value of the home in the market). Bank told you that they can only give you 80% of the amount. And the rest you need to give from your own pocket.

So this, 80% is Loan to Value Ratio. In this case, a bank is paying you a loan on the mortgage of US \$160,000 and you need to pay the US \$40,000 from your own pocket to purchase the home.

For eg:
Source: Loan to Value Ratio (LTV) (wallstreetmojo.com)

Formula

Loan to Value Ratio Formula = Mortgage Amount / Appraised Value of the Property

It is one of the most important risk assessment tools in financial institutions. And before lending the money to the borrowers, lenders examine before approving the mortgage.

Normally, the appraised value of the property is the selling price. But still, the lenders or the banks will send their appraisal team to value the property. And then they would decide to loan the amount (mortgage amount).

In the USA, most of the cases have reported Loan to Value Ratio (LTV) less than 80%. But LTV can be more than that and in that case, the interest rates may go higher.

One thing we need to understand in LTV is this – higher would be the ratio, more would be the risk. So if the lender gives you higher LTV; that means it has more risk inherent within it. And that’s the reason the interest rate would also be higher.

And the borrower also suffers a lot due to a high LTV even if it seems that the borrower is getting the benefit. When the LTV is higher, the cost of the loan increases and as the risk of the lending is much more (as the lender is paying more), the interest rate is much higher. For example, if a borrower borrows money from the bank with a Loan to Value Ratio of 95% would pay at least a 1% higher interest rate than a borrower who has taken a loan with an LTV of 75%.

Interpretation

Now you may wonder why LTV is important and how should we look at LTV in terms of lending and borrowing.

Here’s how LTV affects the lending –

• LTV takes a significant role in securing a mortgage or home equity loan or .
• It also impacts the borrower in a drastic way. The borrower may seem to enjoy initially as his percentage of payment reduces. But if we consider the long term effect, it’s huge and higher LTV forces the borrower to pay much more to the lender over a period of time.
• Now let’s say that as a borrower, you accept a higher Loan to Ratio. What will happen then? If the ratio of the first mortgage is more than 80% then, lenders need (PMI). In this sort of case, the borrowers have an option. First of all, they can talk to the lenders and settle for 80% loan to value ratio and if that doesn’t become sufficient the borrowers can go for secondary financing for the remaining amount necessary.
• Now you need to think that what would give you more benefits? If you go for the first mortgage and reach for a 78% loan to value ratio, private mortgage insurance (PMI) would completely be eliminated. But in that case, the second lien, the interest for which is much more than the first mortgage must be paid off.
• This brings us to another concept altogether which is the extension of the loan to value ratio (LTV) and that is combined loan to value to a ratio (CLTV). CLTV helps the borrowers to keep the LTV low and thus they don’t need to pay PMI at all.

LTV Example

Example # 1

Let’s have a look at the information below –

Now by following the simple formula, we will calculate the loan to value ratio (LTV).

LTV = Mortgage Amount / Appraised Value of Property

For Bank A, LTV would be = (300,000/400,000) = 75%.

For Bank B, LTV would be = (250,000/350,000) = 71.42%.

So what would be the conclusion after calculating the LTV of both of these banks? Here is the conclusion –

First, Bank B has a lower LTV. That means within the loan amount would be lesser and thus, the interest rate would be lower as well. It will help the borrower. But in the case of Bank A, the LTV is a bit higher. But as it doesn’t reach more than 80%, the borrower doesn’t need to give private mortgage insurance.

Now, let’s look at some more examples with different variables.

Example # 2

Let’s have a look at the information below –

In this example, we have not been given the mortgage amount; rather we have the information for the down payment. So how would we Calculate the mortgage amount?

Here’s how – we need to deduct the down payment from the purchase price.

Let’s Calculate it –

Now, we can calculate the loan to value ratio (LTV).

For Bank A, LTV would be = (320,000/400,000) = 80%.

For Bank B, LTV would be = (280,000/350,000) = 80%.

In this case, the ratio for both of these banks is 80%. Now the bank has to decide whether PMI is required for this or not. In most of the case, PMI won’t be required up to 80% of LTV.

Example # 3

Now, let’s see a few additional things so that we can understand the value of the loan to value ratio.

Now, here we have both the purchase price and the appraised value of a property. In this case, what we would take into account while calculating the loan to value ratio?

Here’s the deal. We need to take into account the one which is lesser of the purchase price or the appraised value of a property.

Let’s calculate.

First, we will Calculate the loan amount (mortgage amount).

Now, we would ascertain LTV.

Let’s write down the formula to make a particular thing clear.

LTV Formula = Mortgage Amount / Lesser of Purchase Price or Appraised value of a property.

In this case, both the purchase price and the appraised value of a property are the same. So we would take the same value.

For Bank A, LTV would be = (320,000/400,000) = 80%.

For Bank B, LTV would be = (280,000/350,000) = 80%.

Example # 4

Now, let’s do another example with the different appraised values of the property and purchase price.

This is a different example because you can notice a difference between the appraised value of a property and the purchase price.

First, let’s calculate the mortgage amount.

To get a mortgage amount, we will always deduct the down payment from the purchase price, not the appraised value of a property.

Now, as the purchase price is lesser than the appraised value of a property, we would take purchase price into consideration while calculating a loan to value ratio.

Let’s have a look –

For Bank A, LTV would be = (280,000/360,000) = 77.78%.

For Bank B, LTV would be = (260,000/330,000) = 78.79%.

In this case, we can see that the LTV of Bank B is slightly more than Bank A.

Example # 5 (Combined LTV)

Now there are cases where one person takes two loans to reduce the LTV and so that he needs to incur lesser costs. In that case, we need to Calculate Combined LTV.

Let’s look at an example.

The combined LTV has a simple formula. Here it is –

CLTV = Loan 1 + Loan 2 / Total Value of the Property

Let’s calculate the Combined LTV for Bank A now –

(200,000 + 50,000)/400,000 = 62.5%.

Now this LTV is much lower. Usually, if the borrower has a good credit score, then the bank allows an LTV of more than 80%. And if the borrower doesn’t have a good credit score, usually, lenders don’t go above 80%.

Loan to Value Ratio Example of Used Car Loans & New Car Loans

In this section, we will look at the LTV of two almost similar industries. We take examples of two almost similar industries so that we can understand the value of the loan to value ratio and how drastically different they both are.

First, let’s have a look at the example of used car loans –

From the above graph, it’s clear that this industry’s LTV ratio is too high. It has even touched 99% in some cases. From the observation, we find that the loan to value ratio is always above 90%.

Let’s have a look at the new car loan industry in the US.

In the above graph, we can see that the LTV ratio for new car loans is almost 10% lower than the LTV for used cars. And for new car loans, the loan to value ratio is within the range of 80-90%.

Now the question is why so? Why loan to value ratio for used car loans is higher than the loan to value ratio for new car loans? There may be two particular reasons for that –

• First, maybe the creditworthiness of the used car owners is more doubtful than the new car users. Thus, the risk is more and that’s the reason LTV is more in case of used car loans.
• Second, as the buyers for new cars would be paying much more (as the price of new cars would be more than used cars), they are more trustworthy in terms of payment of EMI.

Limitations

LTV is very useful in terms of lending money to borrowers. But there are a few things you need to keep in mind. This is applicable if the LTV is high.

• The interest rate would be much higher which will increase your total amount payable in the long run.
• You need to pay private mortgage insurance (PMI) if LTV is more than 80%. In that case, you may go for a second lien (think about combined LTV).
• If your loan to value ratio is more than 100% (which is called an underwater mortgage), you will not get any .

In the final analysis

The loan to value ratio is very useful for both lenders and borrowers. But both of them should keep it under 80% to ensure lesser risk and better business consequences.