What is the Loan to Value Ratio?
Loan to value ratio is a financial term used in the banking sector to represent the value of loan against the value of the asset being offered a mortgage. The ratio is used only for mortgage-based loans. It will give an indication of whether the loan is risky or not. It also represents the extent of one’s own ownership and investment in the asset being financed.
Loan to Value Ratio can be calculated by using the following formula.
Example of Loan to Value Ratio (With Excel Template)
Let’s take an example to understand the calculation in a better manner.
A person is planning to buy a house worth $1,00,000 (as valued by the valuer). He has $30,000 available with himself so as to make the down payment. He will be required to avail a loan of remaining $70,000 to finance the loan.
Loan to Value Ratio is calculated using the formula given below
Loan to Value Ratio = Loan Value / Mortgage Value
- Loan to Value Ratio = 7,00,000 / 1,00,000
- Loan to Value Ratio = 0.7
The ratio, in this case, comes out to be 0.7
Importance of Loan to Value Ratio
The ratio is of very much importance to the lenders. It helps the lenders to determine the risk involved in the lending considering the value of the property. By analyzing this ratio, the lender would like to assure itself that they do not lend more than the actual value of the property (which is represented by mortgage value in the formula). Many banks and even some financial regulators may define the maximum ratio as an eligibility criterion for availing a loan. The ratio forms the basis for a bank’s decision as to whether the loan can be approved or not. However, the bank will also consider other facts such as credit score, repayment history and so on before approving the loan.
For banks, a lower ratio is always better and thus for a loan with a lower ratio, the chances for approval will be higher. Also, in case of a lower ratio the borrower can negotiate for other terms of the loan such as interest rates since due to the lower ratio, the loan is less risky. The ratio also represents one’s equity i.e. ownership in the asset and as such a lower ratio will represent that you have a greater amount of equity in the said asset. On the other hand, if the loan to value ratio for a loan is high, there are minimum chances of the loan getting approved since there is a greater amount of risk involved here. This is because there is less amount of equity contributed by the borrower and hence the chances of non-repayment are high!
Advantages and Disadvantages
Below we will see the advantages and disadvantages for the same:
- It helps the lenders to analyze the risk involved in granting mortgage-based loans to the borrowers.
- The borrowers with a lower ratio enjoy beneficial rates of interest along with other benefits.
- The loan gets approved earlier and with ease if the ratio is on a lower side.
- The ratio considers only the primary mortgage involved in the loan. But it does not take into account other considerations such as a secondary mortgage. It is for this reason that a combined loan to value ratio is considered to be more useful.
- As far as borrowers are concerned, the higher ratio will attract a higher rate of interest and also the chances of loan approval become complicated.
Thus, it is important to check the availability of funds with yourself and based on that only you should apply for a loan. Based on your ratio, compare the rates being offered to you by various banks and proceed accordingly.
This is a guide to the Loan to Value Ratio. Here we discuss how to calculate Loan to Value Ratio along with practical examples. We also provide a downloadable excel template. You may also look at the following articles to learn more –