Loan-to-Value as an Indicator of Default Risk
The loan-to-value ratio is a measure that correlates the loan amount to the value of a real estate property, vehicle, or another asset. It is used by financial institutions as an indicator of risk.
Calculating LTV
As a rule, borrowers with a high loan-to-value ratio are considered high risk by financial institutions. They are offered high interest rates and unfavorable conditions. Alternatively, borrowers are required to buy private mortgage insurance. This increases the cost of borrowing. LVR is calculated by dividing the amount by the appraised value. For instance, if you apply for a $55,000 loan to buy a house that costs $85,000, the value is 64.7 percent. For most financial institutions, the threshold is 75 percent meaning that your application is likely to get approved. LTV is an important indicator for financial institutions, but they take other factors into account. These include credit rating, income level, employer, employment history, and many others. Banks look at factors such as repayment and borrowing history, missed and late payments, delinquencies, etc.
Loan-to-value Calculators and Other Methods
This is an easy to use tool that allows you to calculate your LTV based on your outstanding balance and your property’s market value or appraised value. There are also options for borrowers who have a second lien or mortgage. In this case, you need to add all liens, including mechanics, tax, and others. Another way to do this is to use the property’s sales price. Two other factors are the mortgage amount and the down payment. For example, if you want to finance the purchase of a $350,000 home and have $55,000 for the down payment, the loan amount is $350,000 - $55,000 = $295,000. Then this amount is divided by the sales price of the property. The ratio is also used for refinancing purposes. If the loan amount is higher than your home’s value, you may get approved for refinancing. Some financial institutions offer refinancing programs for applicants with a ratio of 100 percent and higher. However, only borrowers with good and outstanding credit qualify. You can also calculate the ratio on your existing loan. In this case, you need the current value (an appraiser can help you with this). Check your mortgage statement to determine the outstanding balance. Divide the current value by the mortgage balance.
Variations
The CLTV or combined loan-to-value ratio is one variation that helps financial institutions assess the risk of default. Applicants with a ratio of 80 percent and higher are likely to get approved provided that they have an excellent or very good credit score. This indicator is used when the borrower applies for more than one credit. For example, a borrower plans to finance the purchase of a $280,000 property. He applies for 2 loans, one for $80,000 and another for $130,000. The combined value is $210,000. Then the CLTV is $210,000/ $280,000 = 75 percent. The debt-to-income ratio is another variation used by financial institutions. This ratio shows what portion of the income of the applicant goes toward principal and interest payments. The lower the figure, the better your chances of getting approved. There are easy to use online calculators. You just plug in your monthly debt and gross monthly income. For example, if your recurring monthly debt is $750 and your monthly income is $2,500, your debt-to-income ratio is 30 percent. Likely candidates have a DTI of less than 36 percent.
Ways to Reduce Your LTV
There are several ways to lower your ratio and a higher down payment is an obvious one. You can either use money in your savings account or sell some asset to offer a higher down payment. Another option is to buy a property that is offered for less than its appraised value. When looking for potential lenders, it helps to calculate your ratio in advance so that you have a good idea of the required mortgage amount and down payment.
Some financial institutions offer loans to borrowers with a high LTV. They are designed for moderate income and low income households. In most cases, they are subsidized by the local authorities or the state governments.
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