Loan-to-value (LTV) ratio is a financial term helpful to express the relationship between the amount of a loan and the value of the collateral that secures the loan. It is described as a percentage and an essential factor that lenders consider when deciding whether to approve a loan application.
LTV is computed by dividing the loan amount by the appraised value of the collateral. For example, if a borrower requests a loan of Rs.5,00,000/- and the collateral is a property appraised at Rs.8,00,000/-, then the LTV ratio is –
Why is LTV Ratio Important?
Lenders use the LTV ratio to assess the risk of a loan application. If the LTV ratio is high, it means that the borrower is requesting a loan that is close to or greater than the value of the collateral. This increases the risk of default because the collateral may need to be more sufficient to cover the outstanding loan amount in case of a default.
On the other hand, if the LTV ratio is low, it means that the borrower is requesting a loan significantly less than the value of the collateral. This reduces the risk of default because the lender has a more significant margin of safety.
The LTV ratio is significant for secured home, car, and business loans. In these cases, the collateral is typically the property, vehicle, or business assets the borrower purchases with the loan. If the borrower defaults on the loan, the lender can seize the collateral and sell it to recover the outstanding loan amount.
LTV ratio also affects the terms of the loan. If the LTV ratio is high, the lender may charge a higher interest rate or require the borrower to provide additional collateral or a co-signer to reduce the risk of default. If the LTV ratio is low, the lender may offer a lower interest rate or more favorable terms because the loan is less risky.
Examples of LTV Ratio
- Home Loan
Suppose a borrower wants to purchase a property worth Rs.50,00,000/- and is applying for a home loan of Rs.40,00,000/-. The lender appraises the property and values it at Rs.55,00,000/-. In this case, the LTV ratio would be –
This means that the borrower is requesting a loan close to the property’s value, which may increase the risk of default.
- Car Loan
Suppose a borrower wants to purchase a car worth Rs.8,00,000/- and is applying for a car loan of Rs.6,00,000/-. The lender appraises the car and values it at Rs. ,00,000/-. In this case, the LTV ratio would be –
This means that the borrower is requesting a loan close to the car’s value, which may increase the risk of default.
- Business Loan
Suppose a borrower wants to start a new business and is applying for a business loan of Rs.20,00,000/-. The lender requires the borrower to provide collateral in business assets worth Rs.30,00,000/-. In this case, the LTV ratio would be –
This means that the borrower is requesting a loan significantly less than the value of the collateral, reducing the risk of default.
Factors that Affect LTV Ratio
- Collateral Value: The value of the collateral is a critical factor in determining the LTV ratio. If the collateral is worth more, the LTV ratio will be lower, and the loan will be less risky.
- Loan Amount: The loan amount is another factor that affects the LTV ratio. If the loan amount is higher, the LTV ratio will be higher, increasing the default risk.
- Credit Score: The borrower’s credit score is another factor affecting the LTV ratio. If the borrower has a high credit score, the lender may be willing to offer a higher loan amount at a lower LTV ratio.
- Loan Type: Different types of loans have different LTV ratios. For example, home loans typically have a maximum LTV ratio of 80-90%, while car loans may have an LTV ratio of up to 100%.
- Market Conditions: The market conditions can also affect the LTV ratio. During a recession, lenders may be more cautious and require lower LTV ratios to reduce the risk of default.
Importance of LTV Ratio for Borrowers
Borrowers should also pay attention to the LTV ratio when applying for a loan. A high LTV ratio means that the borrower is taking on more debt relative to the value of the collateral, which increases the risk of default. This can result in higher interest rates, stricter loan terms, and additional collateral requirements.
Therefore, borrowers should keep the LTV ratio as low as possible. This can be done by increasing the amount of the down payment, negotiating the loan amount, or improving the credit score.
Loan-to-value (LTV) ratio is an essential factor that lenders consider when assessing the risk of a loan application. It expresses the relationship between the loan amount and the value of the collateral that secures the loan. A high LTV ratio means that the borrower is requesting a loan that is close to or greater than the value of the collateral, which increases the risk of default. A low LTV ratio means that the borrower is requesting a loan significantly less than the value of the collateral, reducing the risk of default.
LTV ratio affects the loan terms, such as interest rates and loan tenure. Therefore, borrowers should aim to keep the LTV ratio as low as possible by increasing the down payment, negotiating the loan amount, or improving the credit score. By understanding the LTV ratio and its significance, borrowers can make informed decisions when applying for a loan and reduce the risk of default.