What is the Loan-to-Value Ratio?
The loan-to-value (LTV) ratio is a financial ratio that compares the size of a loan to the value of an asset that is purchased using the proceeds of the loan. The LTV ratio is an important metric that assesses the lending risk that a lender carries by providing the loan to a borrower.
The value of an asset is generally determined either by independent appraisers or the most recent purchase price of an asset. Commonly, when both values are known, a lender will choose the lesser of the two values.
Importance of the Loan-to-Value Ratio
Generally, a high LTV ratio indicates a high level of lending risk. The rationale behind it is that the purchased property (e.g., house) in the mortgage is used as collateral. Thus, the LTV ratio essentially compares the size of the loan requested to the size of the pledged collateral.
Due to the abovementioned reason, the assessment of the LTV ratio serves a crucial role in mortgage underwriting. For example, conventional mortgage lenders usually provide good loan terms if the LTV ratio is less than 80%.
For applicants whose LTV ratio exceeds 80% but still below 100%, loans can still be provided if the applicant possesses a strong credit history. However, the loan terms will likely include higher interest rates and will require the purchase of the private mortgage insurance (PMI). Loans with the LTV ratio above 100% is likely to be rejected.
Formula for the Loan-to-Value Ratio
The general formula for calculating the loan-to-value ratio is:
Example of Loan-to-Value Ratio
Sam is applying for a mortgage from a bank to buy a new house. He needs to borrow $500,000. However, the bank wants to assess the risks associated with the loan by calculating the loan-to-value ratio.
An independent appraiser’s determined that the current value of the house that Sam wants to purchase is $700,000. Therefore, the loan-to-value ratio of the mortgage is:
The loan-to-value ratio of 71% is generally considered to carry a relatively low risk to the lender. Thus, the bank is likely to approve Sam’s mortgage application.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: