Loan-to-Value (LTV) Ratio: Understanding Risk & Home Equity

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 this is that the purchased property (e.g., house) in the mortgageMortgageA mortgage is a loan – provided by a mortgage lender or a bank – that enables an individual to purchase a home. While it’s possible to take out loans to cover the entire cost of a home, it’s more common to secure a loan for about 80% of the home’s value. is used as collateral. Thus, the LTV ratio essentially compares the size of the loan requested to the size of the pledged collateralCollateralCollateral is an asset or property that an individual or entity offers to a lender as security for a loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower default in his payments..

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 is still below 100%, loans can still be provided if the applicant possesses a strong credit historyFICO ScoreA FICO score, more commonly known as a credit score, is a three-digit number that is used to assess how likely a person is to repay the credit if the individual is given a credit card or if a lender loans them money. FICO scores are also used to help determine the interest rate on any credit extended. However, the loan terms will likely include higher interest rates and will require the purchase of private mortgage insurance (PMI). Loans with an LTV ratio above 100% are 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.

More Resources

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