Abbreviated as LTV, the loan to value ratio is a risk assessment measurement.
It is used to calculate the amount that has been loaned as a percentage of the collateral’s appraised value. Basically, it is a ratio that compares the purposed loan amount with the value of the property that’s being purchased – this determines the risk of the loan, namely, its risk of becoming upside-down.
The loan to value ratio is usually used in the mortgage industry. Financial institutions rely on this ratio to determine the amount of money a person has to pay up front when purchasing a home. In short, it is the collateral that has to be paid in order to secure a loan.
The Basics of Loan to Value
What you have to keep in mind is that every single lender out there will have different requirements – and you must fulfill these if you want them to issue a mortgage for you.
For example, if you don’t meet a maximum loan to value ratio, there’s a chance that the lender won’t issue that mortgage. On the other hand, there are also lenders that modify the terms of their loan in order to accommodate for the added risk – this is done by increasing the interest rate or, in some cases, by asking you to purchase mortgage insurance.
This insurance, also known as private mortgage insurance comes with a policy that protects the lender in case the borrower defaults. Obviously, if you can’t pay your debts, the lender will receive money from the insurance company.
Purchasing an insurance is preferred by most people out there, as they can get qualified for a certain loan only by making a small monthly payment to their insurance along with their mortgage payment.
The Formula of Loan to Value
It’s a simple division! In order to come up with the loan to value ratio, you have to divide the mortgage amount by the appraised value of the property – namely, the appraised value of the home you want to purchase.
It’s important to know that the bank wants to make sure that the loan is going to be properly collateralized. Therefore, you might be required to hire an appraiser in order to correctly value the property you are going to buy.
Naturally, the price of a home might not always reflect its true value on the market. Moreover, the banks won’t want to issue a mortgage that’s worth two times more than the value of the property you want to buy.
Thus, the banks are not looking for profit in this case – even though you want to pay more than the real value of a certain property, if the bank chooses to properly appraise it, it won’t mean it has made a poor investment. After all, that’s what properly collateralized means, right?
The average loan to value rate in the US is of 80%. Therefore, the issued mortgage won’t be more than 80% of the appraised value of a certain property.
If a borrower wants a mortgage of more than 80% of the property’s value, he or she will be required to pay a higher private mortgage insurance and interest rate and have a specific credit score as well.