## What is Loan to Value Ratio?

A ratio of the amount of loan with respect to the total value of a particular asset is known as

Loan To Value Ratioand it 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.

To understand Loan to Value Ratio (LVR), 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 LVR 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.

Let’s have a look at the formula to understand LVR in more detail.

### Loan to Value Ratio Formula

First, let’s have a look at the formula and then we will discuss what it means –

**Loan to Value Ratio (LVR) = Mortgage Amount / Appraised Value of the Property**

Loan to value ratio 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 (LVR) less than 80%. But LVR can be more than that and in that case, the interest rates may go higher.

One thing we need to understand in LVR is this – higher would be the ratio, more would be the risk. So if the lender gives you higher LVR; 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 LVR even if it seems that the borrower is getting the benefit. When the LVR 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 LVR of 75%.

Also, checkout DSCR Ratio

### Interpretation

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

Here’s how LVR affects the lending –

- Loan to Value Ratio takes a significant role in securing a mortgage or home equity loan or line of credit.
- Loan to Value Ratio 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 LVR 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 loan to value ratio of the first mortgage is more than 80% then, lenders need private mortgage insurance (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 (LVR) and that is combined loan to value to a ratio (CLVR). CLVR helps the borrowers to keep the LVR low and thus they don’t need to pay PMI at all.

### Example

In this section, we will understand the Loan to Value Ratio in detail. We will take multiple examples so that we don’t miss out on anything. Let’s get started.

At first, we will take a simple example and calculate the loan to value ratio.

#### Example # 1

Let’s have a look at the information below –

In US $ |
Bank A |
Bank B |

Mortgage Amount |
300,000 | 250,000 |

Appraised Value of Property |
400,000 | 350,000 |

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

LVR = Mortgage Amount / Appraised Value of Property

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

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

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

First, Bank B has a lower LVR. That means the risk inherent 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 LVR 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 US $ |
Bank A |
Bank B |

Purchase Price |
400,000 | 350,000 |

Down Payment |
80,000 | 70,000 |

Appraised Value of Property |
400,000 | 350,000 |

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 –

In US $ |
Bank A |
Bank B |

Purchase Price |
400,000 | 350,000 |

(-) Down Payment |
(80,000) | (70,000) |

Mortgage Amount |
320,000 | 280,000 |

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

For Bank A, the loan to value ratio would be = (320,000/400,000) = 80%.

For Bank B, the loan to value ratio would be = (280,000/350,000) = 80%.

In this case, the loan to value 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 LVR.

#### Example # 3

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

In US $ |
Bank A |
Bank B |

Purchase Price |
400,000 | 350,000 |

Down Payment |
80,000 | 70,000 |

Appraised Value of Property |
400,000 | 350,000 |

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).

In US $ |
Bank A |
Bank B |

Purchase Price |
400,000 | 350,000 |

(-) Down Payment |
(80,000) | (70,000) |

Mortgage Amount |
320,000 | 280,000 |

Now, we would ascertain the loan to value ratio.

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

LVR = 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, LVR would be = (320,000/400,000) = 80%.

For Bank B, LVR 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.

In US $ |
Bank A |
Bank B |

Purchase Price |
360,000 | 330,000 |

Down Payment |
80,000 | 70,000 |

Appraised Value of Property |
400,000 | 350,000 |

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.

In US $ |
Bank A |
Bank B |

Purchase Price |
360,000 | 330,000 |

(-) Down Payment |
(80,000) | (70,000) |

Mortgage Amount |
280,000 | 260,000 |

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, LVR would be = (280,000/360,000) = 77.78%.

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

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

#### Example # 5 (Combined LVR)

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

Let’s look at an example.

In US $ |
Bank A |

Loan 1 |
200,000 |

Loan 2 |
50,000 |

Appraised Value of Property |
400,000 |

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

**CLVR = Loan 1 + Loan 2 / Total Value of the Property**

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

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

Now this LVR is much lower. Usually, if the borrower has a good credit score, then the bank allows an LVR 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 loan to value ratio of two almost similar industries. We are taking the example 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 loan to value ratio example of used car loans –

From the above graph, it’s clear that this industry’s loan to value 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 loan to value ratio for new car loans is almost 10% lower than the loan to value ratio for user 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 LVR 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.

Also, look at Credit Analysis

Let’s have a look at the limitations of the Loan to Value ratio.

### Limitations

LVR 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 LVR 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 LVR is more than 80%. In that case, you may go for a second lien (think about combined LVR).
- If your loan to value ratio is more than 100% (which is called an underwater mortgage), you will not get any tax benefit.

### 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.