What is an LTV ratio?
A loan-to-value ratio (LTV) is defined as an assessment of lending risk that financial lenders will examine before approving a mortgage. In simple terms, it’s a measure of how much money the lender is putting down in relation to how much the property is worth.
Let’s take a look at an example of how this is calculated.
How to calculate an LTV ratio
The loan-to-value ratio is incredibly simple to determine and can be found using the following equation:
LTV = Loan Amount / Asset Value
Let’s say that you are a lender and are lending money to someone who wants to do a fix and flip property valued at $750,000. You decide to lend them $600,000. In this case, your loan-to-value ratio would be:
80% = $600,000 / $750,000
This means that you are lending the borrower 80% of the total value of the property.
Why is the LTV ratio important?
The LTV ratio is an important metric for lenders because it can be evaluated against other factors to help them mitigate their risk. It also lets them know how much of their loan they can expect to recuperate in the event that the borrower defaults.
In the example above, if the borrower never meets any of their payments then the lender could still expect to receive 80% of their money back through the sale of the property. The LTV ratio can be balanced against other factors when assessing whether or not to loan someone money.
For example, if someone has good credit and strong borrowing history then the lender might be inclined to give them a higher LTV. On the other hand, if you are dealing with a riskier borrower then you might opt to offer them a lower LTV.
Let’s look at why that’s beneficial.
Why a lower LTV is better for commercial lenders
A loan-to-value ratio is a balancing act between a lender and borrower to determine who is putting down more money to buy a property.
A high LTV is better for the borrower because it means the lender has agreed to finance the majority of the property. If a borrower secures a 90% LTV ratio on a $100,000 property then it means the lender will be paying $90,000 and the borrower only needs to come up with $10,000.
A lower LTV is better for the lender because it means the borrower has agreed to finance more of the property. If a borrower agrees to a 40% LTV ratio on a $100,000 property then it means the lender only has to pay $40,000 while the borrower pays $60,000.
This provides a better cushion for the lender because they have a significantly lower risk compared to a high LTV.
The LTV ratio is one of the many tools lenders use to evaluating risk. They use the LTV ratio as a potential safety net because it tells them how much of their loan they could recover through the sale of the underlying asset. Experienced lenders will also consider various exit strategies for the property just in case the borrower defaults.