The loan-to-value ratio (LTV) is a financial ratio used by lenders to determine the risk associated with a loan. This, in turn, determines the amount of loan sanctioned by the lender. The LTV ratio calculates the percentage of loan amount sought by the borrower to the appraised value of the property pledged as collateral.
An LTV less than 100% indicates that the property value is more than the loan sought by the borrower and acts as a cushion in case of a default by the borrower. The lender prefers a low LTV and the borrower prefers a higher LTV.
Let’s analyse how the LTV ratio is calculated. We shall also discuss the relevance of LTV for the lender and the borrower, and how it can be an important factor while negotiating the terms of the loan.
How is the ratio calculated?
The formula for calculating loan-to-value ratio is as follows:
|Loan amount required by the borrower|
|Appraised value of the property pledged as collateral|
Let’s say Manish wants to take a loan of Rs. 45 lakhs for purchasing a home in a new property. The property is valued at Rs. 60 lakhs and will be used as a collateral for the home loan. In that case, the LTV is 75%.
Thus, the collateral value is higher than the loan value. In case of a default by Manish, the lender can access an asset valued much more than the loan amount. The risk involved in lending to Manish is reasonable and the lender agrees to disburse the loan.
Let’s assume Manish is buying a flat in an under-construction property. Since the property is not yet constructed, Manish offers a plot of land as a collateral for the home loan.The lender assesses the land value at Rs. 36 lakhs, considering that it is in the city’s outskirts, the hiccups involved in selling land, etc. In that case, the LTV will be 125%.
LTV at 125% means that the value of collateral offered by Manish is not sufficient to cover the loan amount of Rs. 45 lakhs in the case of a default. In that case, the bank may lend Rs. 36 lakhs only and not Rs. 45 lakhs.
Depending on the amount sanctioned by the lender, Manish can calculate the EMIs payable over the loan tenure using the home loan EMI calculator.
Importance for the lender
From the above examples, it is clear that the loan-to-value ratio is essential to the lender. The lender calculates whether the value of security is sufficient for the loan amount sought by the borrower. If yes, the lender is willing to lend. If no, the lender sanctions a partial amount only. The lower the ratio, the lower is the lender’s risk.
In certain cases, the lender may agree to lend even if the LTV is higher. However, the home loan interest rate may be higher than the normal rate or the lender may demand a personal guarantee from a third party. If the borrower needs financing urgently, he may agree to the terms of the lender.
Importance for the borrower
Where a home loan is taken for purchasing a home in a newly-constructed property, the property value is generally sufficient for a low LTV ratio. The LTV ratio can also be low if the buyer is self-financing the property to a certain extent and the loan amount required is lower.
In cases where the LTV is higher, the borrower should be aware that the lender may not sanction the entire loan amount or may sanction the entire amount at a higher interest rate.
Before granting a home loan, the lender considers the loan-to-value ratio as a key factor. Before the loan is granted, many other factors like the borrower’s credit score, repayment capability, etc.
The LTV ratio is a vital negotiating factor for the borrower and the lender. The borrower can negotiate for lower interest rates if the ratio is low. However, if the ratio is higher, the lender may negotiate the loan terms in its favour.