When seeking funding in the form of a loan, there are so many jargons and concepts you need to familiarise yourself with, that lenders use in their financial products so as to avoid signing an agreement for something that you don’t understand. These terms include interest rates, credit history, balloon payments, stamp duty and more. Another term you should familiarise yourself with includes Loan To Value ratio (LVR) which is a common term used by lenders especially in the world of home loans. With that being said, let’s dig deeper into what a Loan To Value Ratio (LVR) is.
What is Loan To Value Ratio (LVR)?
Loan To Value Ratio is a term used by lenders that expresses the ratio of a loan to the value of an asset purchased. It is a number lenders use to determine how much risk they are taking on. It’s also how lenders describe the amount you need to borrow to buy a particular property. We could also say that it measures the relationship between the loan amount and the market value of the asset you are securing the loan for such as a house or car. Normally, loan assessments with high Loan to value ratio are considered high risk loans therefore, the lower the LVR the better.
A lower LVR is considered less risky by lenders hence more ideal.. A lower Loan To Value ratio may be good for a borrower as you will have more equity in your home from the start. When it comes to LVR, 80% is considered as the tipping point. Once your LVR goes over 80%, your loan may start to increase as it means more risk to the lender. Most lenders offer mortgage and home equity applicants the lowest possible interest rate when their LTV ratio is at or below 80%. Note that a high Loan To Value ratio does not exclude borrowers from being approved for a mortgage, although the interest rates will be high. For example, a borrower with an LTV ratio of 90% may be approved for a mortgage but their interest rate will be higher than that borrower with an LTV ratio of 70%. Loan To Value ratio can apply to any secured loan but is most commonly used with a mortgage.
Something you should note is that the limit of what you can borrow varies and is determined by your lender and the circumstances of your loan. Some lenders have a maximum LVR of 90%. This means you need to have a 10% deposit to be eligible for a home loan. Others have a maximum LVR of 95% meaning you could secure a home loan with a 5% deposit.
How is it calculated?
To determine your LTV ratio, you will need to divide the loan amount by the value of the asset then multiply by 100 to get the percentage. Therefore, Loan To Value ratio formula= (Amount owed on the loan/value of asset) multiplied by 100.
Lets say a property is being advertised for the value of $600,000 and you have saved a deposit of $200,000 and you require a loan for the remaining $400,000. That means $400,000/$600,00 multiplied by 100= 67%. For this case, your LTV ratio is below 80% therefore, the lower the percentage the lower the risk and the lower the interest rates. Additionally, the lower the ratio, the greater the chance that the loan will be approved plus its less likely that you will be required to purchase Private Mortgage Insurance (PMI)
Note that your LTV ratio will decrease as you pay down your loan and as the value of your home increases over time. But if the property value drops, eg. housing prices fall significantly in the local market, which can push the LTV higher. In the case where you want to refinance, your lender will have to arrange for a new valuation of your property. This is because the price you paid for your house may be different from its current market value.
How to lower your LTV ratio
Reducing the loan to value ratio on your loans means lowering the total cost over the life of the loan. You can lower your LTV by;
- Make a large down payment. Doing this may take a while and lots of effort but it will be worthwhile. As you have seen in the calculation above, the amount owed is divided by the value of the asset therefore, the less you owe by placing a larger deposit, the lower the LTV ratio will be.
- Opt for more affordable targets. Choosing to buy a smaller or older home as opposed to buying that big flashy dream home you had in mind gives you the chance to save up more and you can use that cash to purchase that home or car or to place as a deposit.
Read more: Fixed Interest Rates; What Are They?