When applying for a loan to finance the purchase of an asset, lenders will use various factors to assess the potential lending risk, including the loan-to-value (LTV) ratio. Therefore, it pays to know just what it is to understand how it affects your borrowing power.
Loan to value ratio is a calculation used by lenders to compare the size of your loan in relation to the value of the asset you are financing or refinancing to help determine whether your loan will be a high LTV loan or a low LTV loan.
A high LTV loan means the requested amount of financing is the same or close to the asset’s appraised value, which leaves zero equity.
Therefore, if the loan were to go into default, the lender would make no profit off the resale of the asset.
Hence, these types of loans typically carry a high-interest rate. And in the event you are purchasing a home, you will most likely also be required to purchase private mortgage insurance (PMI) until the LTV ratio is low, which adds to the total cost of the loan.
On the other hand, a low LTV loan means you are requesting less than the appraised value of the asset you are purchasing or refinancing, so it has equity, which is beneficial to lenders and enables you to qualify for a lower interest rate and more.
To arrive at a loan-to-value ratio, whether purchasing or refinancing an asset, simply divide the amount you’re borrowing by the asset’s price.
This way, you can determine how much you can borrow based on the asset’s price and the lender’s program, which is especially important when buying a property.
If your calculation leads to a high LTV ratio, there are some steps you can take to help lower it, including:
- Put down a large down payment – to increase the amount of money you’ll be investing in the asset, so the less funding you’ll need.
- Purchase a lower-cost asset – so the lower down payment you’ll need to increase the equity.
- Opt for a shorter loan term – to help lower your LTV quicker; however, only if you can afford to pay higher monthly payments.
- Pay extra on your loan- enabling your LTV to decrease quicker with each payment.
This information applies even if you are in the market for how to refinance a car. In fact, according to Lantern by SoFi,” if you extend your loan term or take cash out of your equity, you could wind up owing more than what your car is worth…if you have to sell the car, you’ll need to pay the lender difference,” which is something you don’t want. So be sure to understand how LTV loans work to avoid issues later. Also, compare and check different financial institutes to get the best refinancing options.