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 LTV Ratio which stands for Loan to Value 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 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.

Must Read: Factors To Consider Before Applying For A Loan Against Property

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.

RBI Guidelines on LTV (loan to value ratio)

The Reserve Bank of India has proposed an extension of reduced risk weights on home loans until March 31, 2023, which is expected to bring great benefits to borrowers. As of October 2020, the RBI had already tied risk weights to the loan-to-value (LTV) ratios for new home loans sanctioned until March 31, 2022. This move reflects the recognition of the crucial role the housing sector plays in boosting credit growth. Under the circular, risk weights are set at 35% for new home loans with an LTV ratio of 80% or less, and at 50% for ratios exceeding 80% and up to 90%.

Some Tips For Managing Your LTV Ratio

Understanding the nuances of loan-to-value ratio can potentially save you a significant amount of money by getting you a loan with advantageous terms. Here are some useful tips for managing your LTV ratio better:

• Make a higher down payment. This will help relieve the load on the loan amount, therefore lowering the LTV ratio.
• Perform a thorough property valuation by researching the value of the property you intend to purchase or by enlisting professional help. Properties with a lower valuation can tip the scales and elevate the LTV ratio, which can directly impact your loan amount and rates of interest.

How does LTV impact your loan approval and repayment?

If your loan-to-value (LTV) ratio is higher, lenders may view it as a riskier loan. This is because a lower down payment means owning less of the property, which can be concerning for lenders if you are unable to make your payments. This can have various effects, including higher interest rates and difficulty in refinancing.

On the other hand, lower LTV ratios may offer better rates for refinancing home or vehicle loans. Additionally, a higher LTV ratio also means less equity in the property. To combat this, it is important to consider making a higher down payment or purchasing a cheaper asset with a lower LTV ratio, which can increase your equity over time.

Conclusion

Understanding the Loan-to-Value (LTV) ratio is pivotal for borrowers, shaping the landscape of loan approvals, interest rates, and overall financial management. For those seeking financial solutions, SMFG India Credit provides Loan Against Property and other loan options. As you navigate the world of loans and LTV ratios, consider SMFG India Credit as your partner in financial empowerment.