What is Loan-to-Value (LTV) Ratio, and Why is it Important?
Published: Feb 22, 2023
Apart from affordable home loan schemes, homebuyers often come across several terminologies and criteria set by lenders, mainly related to the minimum down payment to be raised by the borrower, the annual income of the borrower to be eligible for a home loan, and a good credit score, to name a few. Besides this, lenders also set one important criterion, known as LTV, an acronym for Loan-to-Value ratio. If a homebuyer is eyeing a residential property and contemplating how much home loan he or she is eligible for, the lenders here will broadly analyse the Loan-to-Value ratio.
Hence, it becomes essential to understand what is a Loan-to-Value ratio? and why is it important for both lenders and borrowers?
What is a Loan-to-Value Ratio?
A Loan-to-Value ratio or LTV ratio is a metric set by the lender that measures the amount of debt used to buy a home and compares that amount to the value of the property being purchased by the borrower. Simply put, the LTV ratio is a financial ratio that compares the amount borrowed to the market value of the purchased asset. The market price of a property is the amount that would be paid for the asset on the open market between two unrelated parties, the borrower and the lender. A borrower is often surrounded by a dilemma of what a good Loan-to-value ratio is. The higher the Loan-to-Value ratio, the higher the risk for the lender and the lower the LTV ratio, the smaller the loan amount and the higher the down payment. To calculate the Loan-to-Value ratio, lenders divide the total loan amount or outstanding mortgage balance by the property’s current market value and convert it to a percentage. For example, if a housing property is appraised at INR 2 crores and the lender offers you INR 1.5 crore loan amount, the lender will divide INR 1.5 crore over INR 2 crore and multiply by 100 to get the LTV of 75%.
The formula for calculating LTV will be calculated as follows:
LTV = Loan Amount/Property Value*100
Why is Loan-to-Value Important?
Loan-to-Value is an important metric that assesses the lending risk of the lender compared to the borrower’s requirement. The LTV ratio compares the size of the loan requested by the borrower against the size of the collateral being pledged while evaluating the borrower’s loan proposal. In case of any default by the borrower or foreclosure, a higher LTV percentage limits the chances of proceeds of sales to cover the outstanding principal amount and accrued interest rate on the property against loan type of loan. A lower LTV percentage is a saver if the lender has to foreclose on the loan. A Loan-to-Value ratio is important because it helps lenders determine a borrower’s capability for a home loan and rates. However, the importance of the LTV ratio varies from the perspective of buyers to the perspective of lenders.
Through Buyer’s Perspective
A borrower is always on the lookout for a lower LTV ratio in property against loan type, as it directly reflects their interest rate. The amount of loan a borrower gets is determined once the lender calculates the LTV ratio. The higher the loan amount a borrower receives, the higher the interest rate and the lesser the down payment
Through a Lender’s Perspective
A lender determines the LTV ratio before sanctioning the loan amount to determine the creditworthiness of the borrower. A lender finds it mandatory to calculate the LTV ratio to ensure that the amount they lend is not greater than the market value of the housing property. A higher LTV ratio is directly linked to higher interest rates but at a greater risk of repayment. If the borrower somehow fails to repay the borrowed sum, the lender has the authority to take the pledged property for auction, Loan-to-Value being a secured loan.
Before applying for an affordable home loan, assess the loan amount request and ensure that the LTV ratio does not exceed the lender’s disbursal policy. Consider making a sizeable amount of down payment so that you have a smaller principal amount to repay during the repayment tenure. Most lenders often give borrowers access to an online home loan EMI calculator to determine the amount they are supposed to pay during a loan tenure.
To conclude, whether you are applying for a property loan or an auto loan, it is important to understand how the LTV ratio affects the overall borrowing cost, what a borrower can do to decrease the LTV ratio, and how doing so can save the borrower from saving money over the lifetime of the loan tenure.