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Concept of Loan to Value Ratio
A mortgage is a legal document wherein the lender lends money in exchange for the title of the debtor’s property. Until the payment is received for the entire debt, the lender is the title holder of the property which is mortgaged.
There are various types of mortgages. However, despite the type, the lender has to bear significant risk upon lending such large amounts of money. In order to assess the risks, Loan to Value Ratio is used.
Let us understand what this ratio does.
What is Loan to Value Ratio?
Loan to Value Ratio is a risk assessment ratio which compares the value of the asset to the amount of the loan given. Based on the ratio, the cost of taking the loan is calculated. It is expressed as a percentage of the loan to the cost or value of the asset.
Loan to Value Ratio Definition
Thus, Loan to Value ratio can be defined as the amount of the mortgage lien divided by the appraised value of the property and expressed as a percentage. Its various uses are as given below.
Uses of Loan to Value Ratio
The Loan to Value ratio is mainly used to determine the value of mortgage costs. The higher the percentage of Loan to Value ratio, the higher is 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 in turn increases the cost of borrowing. A lower Loan to Value ratio 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.
The Loan to Value 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 real value of the property. The real value of the property would be the value minus the mortgages and loans on it. The loan to value ratio is an indicator of the feasibility of such additional lendings. It has a simple formula as shown below.
Loan to Value Ratio Formula
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 of the cases as there is a good chance of recovery.
This can be explained with the help of a basic example.
Loan to Value Ratio 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 Loan to Value Ratio will be $93,500 / $100,000 or 93.5%.
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 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.
References
- http://www.investopedia.com/terms/l/loantovalue.asp
- https://www.thebalance.com/loan-to-value-ratio-315629
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