Loan to Value Ratio – Meaning, Uses, Formula, and Example

What is Loan to Value Ratio?

Loan to Value ratio (LTV) can be defined as the amount of the mortgage lien divided by the appraised value of the property and expressed as a percentage of the loan to the cost or value of the asset. This ratio is a risk assessment ratio that compares the asset’s value to the amount of the loan given. And based on the ratio, the cost of taking the loan is calculated.

There are various types of mortgages. However, the lender has to bear significant risk upon lending such large amounts of money despite the type. In order to assess the risks, the LTV is used.

Uses of Loan to Value Ratio

• The LTV ratio is mainly used to determine the value of mortgage costs.
• The higher the percentage of this ratio, the higher the credit risk. Therefore, the cost of taking the mortgage goes up in terms of interest rates.
• A high percentage also requires the need to take insurance, which increases the cost of borrowing.
• A lower LTV percentage for the lenders means that they can sell the property at a rate equal to or more than the loan amount in case of a default in repayment.
• This ratio is also used primarily for the purpose of mortgage underwriting. This is done while purchasing residential property, refinancing a current mortgage into new loans, and borrowing against the property’s real value. The property’s real value would be the value minus the mortgages and loans on it.
• This ratio is an indicator of the feasibility of such additional lendings.

Formula of Loan to Value Ratio

The formula used by the lenders to calculate this ratio is as follows:

Loan to Value Ratio = Loan Amount / Appraised Value of Property

What is a Good Loan to Value Ratio?

Although there is no set optimal LTV ratio, all lenders prefer a low percentage as it decreases the credit risk. Around 80% is preferred in most cases as there is a good chance of recovery.

Example

A borrower wants a loan for purchasing a house worth $100,000. The amount of the mortgage given by the lender is $93,500.

The LTV will be $93,500 / $100,000 or 93.5%.

Now, the question comes is what is the remaining 6.5% called in finance. So the answer to this question is that it is called the Haircut in finance. Yes, you read it right the formula calculating a haircut is as under

Loan to Value Ratio + Haircut in Finance = 100%

Thus, this is not a viable ratio for the lender as the percentage is too high. The lender then runs the risk of a loss upon selling the property in case of a default in the repayment. At 93.5%, the lender may not even recover the initial principal amount.

Conclusion

Loan to Value Ratio is a type of leverage ratio and thus makes it easier for lenders to determine the risk and approve the mortgage. However, it must be noted that this is only one determinant and the approval of a mortgage depends on various other subjective factors and criteria.

Show References

1. What Is a Loan-to-Value Ratio? [Source]
2. Loan-To-Value Ratio [Source]