Additional Resources

  1. The Economics Of The Bank And Of The Loan Book [care-mendoza.nd.edu]
  2. Loss Given Default Of High Loan-to-value Residential Mortgages [citeseerx.ist.psu.edu]
  3. Bank Commercial Loan Fair Value Practices [citeseerx.ist.psu.edu]
  4. Loan Valuation, A Modern Finance Perspective [sites.insead.edu]
  5. Borrower Risk Signaling Using Loan-to-value Ratios [pages.jh.edu]
  6. Economic Conditions, Underwriting And Moral Hazard [business.gwu.edu]

Definition

The loan-to-value ratio is a financial term used by lenders to express the ratio of a loan to the value of an asset purchased. The term is commonly used by banks and building societies to represent the ratio of the first mortgage lien as a percentage of the total appraised value of real property. For instance, if someone borrows $130,000 to purchase a house worth $150,000, the LTV ratio is $130,000 to $150,000 or $130,000/$150,000, or 87%. The remaining 13% represent the lender's haircut, adding up to 100% and being covered from the borrower's equity. The higher the LTV ratio, the riskier the loan is for a lender.

Loan to Value

Many banks and financial institutions are often involved in scenarios where a borrower asks them for a loan. They use this risk assessment termed as Loan-To-Value Ratio to analyze the riskiness of the loan. The higher the percentage of the LVR, the riskier the loan is for the lender to approve. This can be explained in simple terms like this:

If a person (borrower) comes to a bank (lender) asking for a sum of money (loan) to purchase a land or equity (value), then the bank (lender) would use the Loan-To-Value Ratio to assess the riskiness of the loan. Working Formula:

Loan to Value Ratio = {Mortgage Amount (the loan) ÷ Appraised Value (for which the loan is taken)} %

The result is in percentage (%) which a bank or financial institution would use to analyze and determine whether the loan is risky or not. Most banks prefer to lend amounts that don’t exceed 75% on the LVR.

Example

Mr. Richardson wants to get a loan of $125,000 in order to purchase a house that is valued at $150,000. He proceeds with his request to a local bank asking about a loan but gets rejected as the bank cannot issue loans that have risk factor higher than 75% on the LVR. This is how it works:

Loan Amount / Mortgage = $125,000

Appraised Value of the Asset / House = $150,000

LTVR = ($125,000 ÷ $150,000) x 100 = 83.33% which is far much greater than 75% which means the loan is far more risky than the financial institution can handle.

However if Mr. Richardson was to get approved for the loan, he must ask nothing more than 75% of the house value to the bank which is $112,500. So if he had asked for a loan of $112,500 from the bank rather than the previous amount, Mr. Richardson could have gotten the loan approved.

Important Note

Though LVR is quick to analyze the riskiness of a loan, it is still another lending risk assessment ratio. This means that while it can be deemed as effective, it is still not a comprehensive enough tool to be used as the only criteria when assessing mortgages.

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