The Loan-to-Value (abbreviated LTV) ratio is a crucial factor in mortgage lending that helps determine the borrowing capacity as well as the risks that are associated with a loan application.
Having a good grasp of the LTV ratio is critical for borrowers as well as lenders as it helps to assess the viability of a property loan as well as the potential for loan repayment. This post is going to take you through the Loan-to-Value concept, the calculation, and its importance in the lending procedure, and the disadvantages.
But first, let us understand what the Loan-to-Value Ratio is.
The Loan-to-Value ratio is a common financial term that is typically used for describing the proportion of a particular loan compared to the total appraised value of the refinanced or purchased property. It is one of the most critical metrics in the entire mortgage industry as it reflects the level of risks associated with the loan.
This LTV ratio is explained as a percentage, and a higher percentage signifies a higher risk for the lender.
How to Calculate the Loan-to-Value Ratio?
To calculate the Loan-to-Value ratio, first, determine the total loan amount you desire to borrow from the lender. In the next step, ascertain the appraised value of the property that is in question. Then, divide the loan amount by the appraised value of the property and multiply the result by 100 to obtain the LTV ratio percentage.
For instance, if you wish to borrow Rs. 40,00,000 for a property that is worth Rs. 50,00,000, the LTV calculation would be:
Loan amount (in INR) divided by the Property value (in INR) multiplied by 100 = LTV Ratio 40,00,000 divided by 50,00,000 multiplied by 100 = 80%
In this scenario, the LTV ratio is 80%, which means that the borrower has been seeking a loan for about 80% of the total property value.
Explaining the Loan-to-Value Ratio
The LTV ratio plays a vital role in the mortgage process, as it helps lenders evaluate the risk associated with a particular loan application. A lower LTV ratio tells that the loan borrower boasts a larger down payment or equity stake in the property, reducing the lender’s risks. A higher LTV ratio shows that the loan borrower is financing more of the property’s value, maximizing the risk exposure of the chosen lender.
Lenders prefer loans that have lower LTV ratios, as they are less risky and offer a more significant cushion in case a borrower defaults on the availed loan. Plus, a lower LTV ratio translates to improved loan terms and loan interest rates for the one availing it.
How do Lenders Use LTV?
Lenders use the LTV ratio to determine their loan eligibility, loan interest rates, and terms of a loan. The LTV ratio is a critical factor in the underwriting procedure, as it helps financial lenders evaluate the potential risks of a particular loan application. Typically, loans with higher LTV ratios are understood to be riskier and may be subject to more stringent underwriting guidelines and/or higher interest rates.
In some cases, lenders may require the borrowers to buy private mortgage insurance (PMI) if the LTV ratio goes above a threshold, typically 80%. The PMI safeguards the lender in case the borrower defaults on the existing loan.
What Are the Major Disadvantages of LTV?
Even though the Loan-to-Value ratio is a very helpful tool for borrowers as well as lenders, it comes with some disadvantages, especially when the LTV ratio is high. Some of the setbacks are:
Limited financing choices: Borrowers who have a high LTV ratio may find it more difficult to secure loans from conventional lenders, as such loans are considered to be riskier. Lenders could be more hesitant to approve high-LTV loans owing to the increased chances of a loan default. As a result, borrowers may have to explore alternative financing options, such as government-backed loans or loans from private lenders, which might have less favorable terms.
Higher interest rates and costs: Higher LTV loans come with a higher interest rate, highlighting the enhanced risks for the lender.
Besides, loan borrowers may be needed to buy mortgage insurance that can boost the overall loan cost.
Lowered home equity: Higher LTV ratios tend to result in lower equity in the selected property for the borrower. Such a reduced equity can make it more challenging to sell or refinance the property in the future, especially if property values fall or stay stagnant.
For instance: A borrower who bought a property with an LTV loan 90% loan has 10% equity in their house. If property values were to lower by 5%, the borrower’s equity would drop to 5%, making it even more difficult to refinance or sell their property without a loss.
Negative equity risk: In some scenarios, a higher LTV ratio can result in negative equity, where the outstanding loan balance far exceeds the property’s value. The situation can happen if the property values decline after the loan has been issued. Make use of a loan to value calculator and/or a property loan calculator to get accurate estimates. Negative equity might make it difficult to sell/refinance the property and may leave the loan borrower vulnerable to foreclosure if they cannot make mortgage payments on time.
In conclusion, the Loan-to-Value ratio is a key metric in the mortgage lending procedure that is used to evaluate the risks associated with a particular loan application. A lower LTV ratio is more favorable for the borrowers, as it signals a lower level of risks for the lender and may also result in lower interest rates as well as better loan terms.
To seek an appropriate LTV ratio, try to apply for home loans with reputed financial lenders. These lenders provide appealing LTV ratios for home loans, making sure that you benefit from the loan’s competitive interest rates, quick fund disbursal, as well as flexible repayment terms.