What is Loan-to-Value Ratio?
The Loan-to-Value Ratio (LTV) refers to the relationship between a loan amount and the appraised fair value of the asset securing the loan, e.g. property, home, automobile.
How to Calculate Loan-to-Value Ratio (LTV)?
The loan-to-value ratio (LTV) is a metric frequently calculated by financial institutions and lenders to measure credit risk, particularly when considering mortgage applications.
In the context of real estate underwriting, lenders often compare the total dollar value of their loan to what the borrower is contributing, which is the value of the property securing the loan.
The loan-to-value ratio (LTV) measures the relationship between two factors:
- Secured Loan Amount
- Value of Purchased Asset
Further, the loan-to-value ratio can be calculated by dividing the loan amount by the appraised property value.
Loan-to-Value Ratio Formula (LTV)
The formula for calculating the loan-to-value ratio (LTV) is as follows.
- Loan Amount → The size of the financing provided by the lender.
- Appraised Property Value → The estimated fair market value (FMV) of the property on the present date.
Since the LTV is frequently expressed as a percentage, the resulting figure should then be multiplied by 100.
Lenders use the LTV ratio as part of the underwriting process to gauge the amount of risk undertaken if the loan is approved.
What is a Good Loan-to-Value Ratio?
In reality, there is no quick-and-easy method to reduce the LTV ratio, as the process can be time-consuming and require some patience.
One option is to spend more on the down payment before taking out the loan; however, not every homebuyer (or borrower) has this option.
For those who cannot increase the down payment, the best course of action could be to consider waiting to grow your savings and purchase a more affordable home or car with a lower price tag.
While not ideal, the compromise can pay off in the long run — so when the time comes, you can make a larger down payment and own more equity in the property.
Generally, the lower your LTV, the better off you’ll be over the long term in terms of interest rates and lending terms.
Another consideration is to get your property re-appraised, especially if there is reason to believe that the property value might have risen over the years (e.g. neighboring properties have also increased in value).
If so, refinancing or taking out a home equity loan can become easier.
- Refinancing Loan → Refinancing can be negotiated at a lower interest rate since LTV is based on the appraised value rather than the original purchase price.
- Home Equity Loan → Home equity loans are borrowings against the equity on the property, which is beneficial for the borrower if the home’s value has been re-valued at a higher value.
How to Interpret LTV Ratio in Real Estate?
Higher loan-to-value (LTV) ratios tend to be perceived as riskier financing arrangements by most institutional lenders, such as real estate lenders.
- High Loan to Value (LTV) → More Credit Risk + Higher Interest Rate
- Low Loan to Value (LTV) → Less Credit Risk + Lower Interest Rate
In the context of real estate mortgages, the LTV can determine the necessary down payment, the total amount of credit extended, the terms of the loan, and more (e.g. insurance policy).
Typically, banks and lending institutions view an LTV of 80% or less as favorable and are far more likely to offer favorable terms in such cases, i.e. lower interest rates.
Therefore, a higher LTV can negatively affect the borrower in several ways, such as:
- Higher Interest Rates
- Higher Monthly Payments
- Private Mortgage Insurance (PMI)
- Less Equity in Property (i.e. Smaller-Sized Down Payment)
Combined Loan to Value Calculation (CLTV)
The combined loan to value (CLTV) measures two mortgages combined against the appraised property value.
For instance, let’s assume that you already have a mortgage but have decided to apply for another.
The lender will evaluate the combined LTV (CLTV), which factors in the following:
- Outstanding Loan Balance on the 1st Mortgage
- Newly Proposed 2nd Mortgage
If the current outstanding loan balance is $240,000 on a recently appraised home at $500,000, but now you want to borrow an additional $20,000 in a home equity loan for backyard renovations, the CLTV formula is as follows.
- Combined Loan To Value (CLTV) = ($240,000 + $20,000) / $500,000
- CLTV = 52%
Loan-to-Value Ratio Calculator (LTV)
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Home Mortgage Financing Assumptions
Suppose you have decided to purchase a home currently worth $400,000 in the market based on a recent appraisal.
Since you do not have enough cash on hand to purchase the house all by yourself, you resort to getting assistance from a bank that offers to provide 80% of the total purchase price, i.e. $320,000.
The remaining 20% must be paid out of your pocket.
- Total Purchase Price = $400,000
- Mortgage Loan = $320,000 (80% of Total Purchase Price)
- Down Payment = $80,000 (20% of Total Purchase Price)
2. Loan-to-Value Ratio Calculation Example (LTV)
In conclusion, we arrive at a loan to value (LTV) ratio of 80%, wherein the bank has agreed to provide a mortgage loan of $320,000 while $80,000 is your responsibility.
- Loan-to-Value Ratio (LTV) = $320,000 ÷ $400,000 = 80%
The 80% loan-to-value ratio (LTV) means the lender is funding 80% of the total purchase price in the form of a mortgage loan, while the remaining 20% is contributed by the borrower.
