What is Loan-to-Value Ratio and Why is it Important?

There are a lot of technical terminologies around loans and mortgages; it could be a home loan, project finance, gold loan, or even a car loan. One such relevant term is the Loan to Value ratio (LTV Ratio).

To get a fair idea on this, let us dive deeper into what a Loan-To-Value Ratio is, how it works, and the kind of difference it creates for both the parties to the transaction, i.e. the lenders and the borrowers.

What is a Loan To Value Ratio?

Loan-To-Value Ratio (LTV Ratio) or Loan-To-Cost Ratio (LTC Ratio) is as simple as it sounds. It determines nothing but the maximum amount based on the market value and liquidity of the asset pledged as collateral in case of a secured loan. In simpler terms, borrowers allow the lenders a claim to the asset, in case they are not in a position to repay the loan at any given point in time. LTV simply tells the loan applicant the maximum percentage of the value of the pledged asset that he can borrow.

How Does it Work?

The final amount of borrowing is determined on multiple factors including but not limited to the value of the security, eligibility of the borrower, a good CIBIL Score, etc. To determine the maximum amount that can be lent, the financial institution shall use this LTV ratio to cap the maximum amount of loan depending on the value of the security. Let us understand the calculation of the LTV ratio.

Calculation of Loan-To-Value Ratio:

LTV = (Loan amount/Appraised value of the asset) x 100

Suppose, a borrower is seeking a loan against the property of INR 50 Lakhs urgently and the lender after ticking off the basic loan against property eligibility criteria as above checks out the amount to be sanctioned to be INR 40 Lakhs then the LTV ratio would be as follows –

LTV = (40 Lakhs/50 Lakhs) x 100 = 80%

The above example states that the lender would sanction INR 40 Lakhs. Lenders determine the LTV after appraising the value of the asset pledged. For instance, if the pledged asset is a house, which is brand new, and has been built in a prime location, then the loan amount given loan against the property is higher (75% – 80%). On the other hand, older properties which may become more cumbersome to sell or whose value may not increase attract lower loan amounts.

Higher or Lower LTV – Which one is Better?

Lender’s Perspective

Considering from the lender’s perspective, a lower LTV is suitable as it requires the borrowers to pump in more of owned funds, ensuring a higher level of commitment from the borrower. The lenders, however, guarantee that the interest rates are high to secure the risk of a higher LTV ratio. Therefore, the interest rate is directly proportional to the LTV ratio, i.e. higher risk higher reward. On the other hand, lenders also take into account the fact that older assets that depreciate in value may become a burden to them for resale in case of default and in such cases, reject the loan application altogether.

Borrower’s Perspective

A Higher LTV ratio is more lucrative for the buyer to process the loan quickly. In the initial stage, the borrower gets the maximum sourced finance resulting in immediate stepping up in the ladder for the objective for which credit is being taken. The higher LTV further allows the borrower to negotiate for a longer tenure of loan and lesser interest rate.

Why does LTV Ratio Hold Importance?

The LTV ratio is an important metric that assesses the lending risk a lender bears by providing a loan as per the borrower’s requirement. The rate compares the size of the loan requested against the size of the collateral pledged while evaluating the borrower’s loan proposal. In case of foreclosure or default by the borrower, higher LTV limits the chances of proceeds of sales to cover the outstanding principal and accrued interest. As against this, a lower LTV is a saver if the lender has to foreclose on the loan.

Therefore, analyzing both sides by the study of the LTV ratio is of utmost importance.