LTV (Loan-to-Value)

What is LTV (Loan-to-Value)?

LTV represents the proportion of an asset’s value that a lender is willing to provide debt financing against. It’s usually expressed as a percentage.

LTVs tend to be higher for assets that are considered more “desirable” as collateral. The desirability of an asset as collateral is generally measured by how stable its value is, how active its secondary market is, and how easily the title can be transferred to other parties (among other things).

How is LTV Calculated?

Broadly speaking, the formula is:

LTV % = (Loan Amount / Asset Value) * 100

Practically speaking, however, LTVs can be calculated or derived in a few ways; it depends on the starting point. Here are several examples:

Minimum equity requirement

Residential real estate is a good example.

It could be that a lender has a “minimum equity” requirement (think of a home purchase) – maybe that’s not-less-than 5% (0.05) down payment towards the purchase price. In that case, the maximum LTV would be 95% (1-minus 0.05), multiplied by 100 to express as a percentage.

Maximum risk appetite

A commercial borrower looking to finance manufacturing equipment will serve as a good illustration. 

Many commercial lenders will want to ensure there’s a buffer between the loan amount and the asset’s value. Perhaps the risk team at a financial institution feels confident that they could liquidate the equipment pretty easily at a 25% discount.

That likely implies they’re willing to extend not-greater-than 75% LTV against the asset. Think of it as 1-minus the “equity buffer.”

Cash flow

Commercial mortgages are an example. Many commercial mortgage lenders underwrite credit based on the cash flow generated by a property’s tenants. 

In order to do this, they typically use a mortgageability calculation. This is where an analyst will look to understand the future net operating income (NOI) of a property, and, working backward using an implied interest rate and a minimum debt-service requirement, they’ll generate a present value of those future cash flows. 

Whatever that present value is represents the maximum loan amount they’re willing to extend. That loan amount divided by the current appraised value of the property (multiplied by 100) equals the maximum LTV (expressed in percentage terms). 

Why Do LTVs Matter?

A lender extends credit in order to generate interest income. But when a loan goes bad (i.e., delinquent payments, technical defaults, or other covenant breaches, etc.), a lender immediately must turn its attention to mitigating the risk of loan loss.

Loan loss occurs when a lender cannot recoup all of its outstanding loan exposure. One of the best ways to protect against potential loan loss is to ensure that, should a borrower’s financial situation deteriorate and the lender must liquidate assets, there’s a buffer between the outstanding loan amount and the price that the asset could fetch (at auction, or otherwise).

Another reason most lenders aren’t willing to debt finance 100% of an asset’s value is because the borrower isn’t putting up any cash of their own (often referred to as “skin in the game“). When a borrower has no skin in the game, they may be more likely to walk away from a loan obligation (because they have nothing to lose).

LTV: Loan-to-(what?)-Value

Understanding how lenders arrive at an actual value (against which they can extend credit) is an important consideration, too – particularly for commercial lenders. Broadly speaking, there are three main categories of value that are used. These are:

Book value

Book value is the value shown on a company’s balance sheet. When it comes to operating credit, for example, the book value of a firm’s A/R (accounts receivable) is often used as a starting point to calculate a reasonable “borrowing base” for operating credit.

When it comes to fixed assets (and term financing), book value is a much less precise measure of an asset’s actual market value though, since it’s presented net of depreciation. Depreciation is a notional, non-cash expense that’s used for accounting purposes, so book value often doesn’t align with the actual useful life of the underlying asset.

Purchase price/cost

Purchase price is an easy proxy for value, and it’s often used when financing new PP&E (property, plant and equipment). But it only works when a business is purchasing new equipment for which an invoice is being issued and the cost is clear.

If a company is purchasing used equipment or is leveraging clear title assets it already owns, then purchase price is an ineffective means of understanding an asset’s value. In those cases, a lender will look to use an appraisal.

Appraised value

An appraisal is a third-party expert’s estimate of an asset’s value. They’re used for a wide variety of assets, but commercial lenders will most commonly deal with commercial real estate and equipment appraisals. 

The commercial real estate appraisal process is a complicated one, designed to provide not just a range of reasonable value estimates but also to identify property-specific risks and red flags. 

Equipment appraisals are similar to real estate but generally are a little less comprehensive. Equipment appraisals usually include three specific value estimates. These are:

1. FMV (Fair Market Value): FMV is an objective estimate of the asset’s “price” assuming a standard liquidation process with multiple informed bidders.
2. OLV (Orderly Liquidation Value): OLV represents an asset’s liquidation value if it were auctioned off by a lender in an “orderly” fashion, meaning that time was of some essence, but multiple informed parties were present.
3. FLV (Forced Liquidation Value): FLV is the most conservative estimate of an asset’s value. It represents the expected price the asset would fetch without the benefit of an orderly liquidation process.

If a lender’s credit policy permits 75% LTV for used equipment, it’s important that the loan officer, the risk manager, and the client all understand if that’s 75% of FMV, OLV, or FLV in order to ensure that expectations are aligned.

What is a Typical LTV?

LTVs range rather considerably and are largely determined by the lender’s risk appetite and the nature of the underlying asset(s). 

If cash is being used as collateral (maybe for a letter of credit, for instance), then a borrower can probably expect to get 100% LTV. Real estate also tends to support higher LTVs – up to 95% for residential properties and generally upwards of 75% of appraised value for commercial properties. At the opposite end of the spectrum is inventory, which is frequently capped at 50% LTV. 

When it comes to personal lending, rare or customized assets may command among the lowest LTVs. Fine art, wine collections, and collector vehicles may be used as collateral. Still, the niche appeal and limited secondary markets for these assets limit their upside, which equates to a lower LTV (maybe as low as 25-30%).  

LTVs and Market Forces

LTVs matter a lot, but not just for the reasons we’ve outlined. 

All things being equal, most lenders would prefer more restrictive credit structures across the board (including lower LTVS) as these tend to reduce the risk of loan loss. But lenders are also subject to market conditions and competitive forces, just like any other business.

Competition in the banking industry and the finance sector more broadly (including fintechs) has forced many financial institutions to loosen credit policies and increase what is considered “market” LTVs. Those that do not risk missing out on potential new client opportunities.

Financial services providers must constantly evaluate their credit risk appetite within the context of market forces in order to remain competitive (but also prudent) in their loan origination practices.

More Resources

Thank you for reading CFI’s guide to LTV (Loan-to-Value). To keep learning and advancing your career, the following CFI resources will be helpful:

• Free Fundamentals of Credit Course
• Fair Market Value
• Quality of Collateral
• Loan Security
• High-Ratio Loan
• See all commercial lending resources