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Loan-To-Value Ratio – LTV Ratio Definition
The Loan-to-value (LTV) ratio is the ratio of the mortgage amount and the total appraised value of the property. The financial institutions and other lenders calculate this to measure the mortgage risk before approving a mortgage loan. A high loan-to-value ratio indicates a higher risk of default. The lenders approve loans with higher loan to value ratio against a high rate of interest and the debtor may also have to purchase additional mortgage insurance in order to balance the risk.
The Loan-to-value ratio is calculated as
Loan to value ratio= Mortgage Amount / Appraised Property Value
A Little More on What is the Loan to Value Ratio
The loan-to-value ratio is an important component of mortgage underwriting. It helps the lender to estimate the level of the risk they are being exposed to by approving the loan.
For example, Joe Williams decides to purchase a real estate property with $800,000. She puts $ 120,000 down and plans to borrow the rest. So, her loan to value ratio would be calculated as
If a borrower’s LTV crosses 100%, they are considered to be upside down on their mortgages. They owe more on the house than the house is worth, and no equity is built up within the property. These borrowers are more likely to default on the loan and on the occasion of a foreclosure, the lender may find it difficult to sell the property in a price that covers up the outstanding mortgage amount. Generally, the lending agencies prefer an LTV ratio which is lower than 80% and provides better loan term to them. The lender may require the borrower to buy private mortgage insurance if the loan to value ratio of a mortgage loan is higher than that.
The FHA lenders may allow up to 96.5% loan to value ratio while approving a mortgage, but it requires the borrower to pay a mortgage insurance premium as long as the total loan amount is not repaid. It doesn’t matter how the loan to value ratio goes down eventually. So, the borrowers are most likely to refinance their loan to a conventional one, one the loan to value ratio reaches 80%.
The VA loans available to the present and former military personnel and the USDA loans available to the rural population may allow a 100% loan to value ratio. As these loans are fully or partially guaranteed by the government, no additional mortgage insurance is required.
As can be seen in the above calculation, the loan value depends on three factors the sales price of the property, the down payment, and the appraised value. The loan to value ratio can be improved by increasing the down payment or by negotiating a lower sales price. A lower loan to value ratio ensures the approval of the loan without the support of private mortgage insurance, in a lower interest rate.
References for the Loan to Value Ratio
Academic Research on Loan-to-Value Ratio (LTV)
- • Loan–to–value ratio as a macroprudential tool-Hong Kong’s experience and cross-country evidence, Wong, T. C., Fong, T., Li, K. F., & Choi, H. (2011). The study attempts to examine the effectiveness and shortcomings of maximum loan-to-value ratios as a macroprudential tool. The evaluation is done based on the experience of Hongkong and econometric analyses of panel data from 13 economies. The study finds the maximum loan-to-value ratio to be an effective tool in reducing the systemic risk caused by the boom-and-bust cycle of property markets. However, the study also finds a drawback of this tool. It shows the tool could impose higher liquidity constraints on the borrowers. The paper concludes the mortgage insurance programs can overcome this drawback without undermining its effectiveness.
- • Research On Loan–to–value Ratio of Inventory Financing under Randomly-fluctuant Price [J], LI, Y. X., FENG, G. Z., & XU, Y. (2007). Systems Engineering-Theory & Practice, 12, 42-48. The paper analyzes the loan-to-value ratio decision of banks in inventory financing, given the price of the pledged stock fluctuates randomly. It implements risk estimation strategies of “main body+ debt” in this study.
- • Research on Loan–to–value Ratio of Inventory Financing When Demand Is Stochastic [J], ZHANG, Q. H., & ZHAO, Q. W. (2010). Chinese Journal of Management Science, 5, 004. The paper analyzes the decision of loan-to-value ratio of stock financing, under the assumption of endogenous default risk and stochastic demand. The research establishes that optimal decisions under risk averse and loss averse are always lesser than that of risk neutral.
- • Residential mortgage default risk and the loan–to–value ratio, Wong, J., Fung, L., Fong, T., & Sze, A. (2004). Hong Kong monetary authority quarterly bulletin, 4, 35-45. The study assesses the impact of negative equity on the risk of mortgage default. It finds that the default risk of mortgage is positively correlated with the current loan-to-value (CLTV) ratio, unemployment rate, and interest rate and negatively correlated with financial market sentiment. The study strongly supports the policy of adopting a maximum of 70% loan-to-value ratio in residential mortgage.
- • Optimal loan–to–value ratio and the efficiency gains of default, Lin, L. (2014). Annals of Finance, 10(1), 47-69. The paper studies the optimal loan-to-value ratio in a monetary general equilibrium model with collateral default, heterogeneous agents, production and a banking sector. The study finds that tighter financing constraints can improve the welfare for the borrower. It also finds that the optimal LTV ratio for both the borrower and lender opens the possibility of ex post default.
- • Effectiveness of loan–to–value ratio policy and its transmission mechanism–empirical evidence from Hong Kong, Wong, T. C., Ho, K., & Tsang, A. (2015). A non-technical summary of two recent studies is presented in this paper with an aim to evaluate the loan-to-value (LTV) policy as a macroprudential tool including its effectiveness, shortcomings and its transmission mechanism for improving financial stability. The empirical studies show that LTV policy helps to decrease the systematic risk caused by the boom-and-bust cycles of the property market. The paper identifies that this policy may put higher liquidity constraints homebuyers but suggests that the mortgage insurance program has the ability to overcome the shortcoming of the tool without undermining its effectiveness. The evidence also shows that the policy pass-through to property market activities may be weak. Household leverage and credit growth can be reduced by tightening LTV cap and lower leverage strengthens banks’ resilience to property price shocks. The paper concludes that an optimal target of LTV policy is household leverage.
- • The impact of financial stability reports’ warnings on the loan–to–value ratio. Alegría, A., Alfaro, R., & Córdova, F. (2016). mimeo, BIS CCA CGDFS working group. The paper discusses the impact of central bank communication on macroprudential supervision. It presents evidence of how the bank lending policies were affected by the specific warnings published in the Central Bank of Chile’s Financial Stability Reports of 2012. The paper shows how it was rebalanced by reducing the number of a mortgage loan with high loan-to-value ratios and increasing the loans with lower LTV ratio.
- • Should Loan–to–Value Ratio Restrictions be Imposed on National Banks’ Real Estate Lending Activities, Feder, D. E. (1987) Ann. Rev. Banking L., 6, 341. The federally chartered and many state-chartered savings and loan associations are bound by some restrictions while issuing a loan. The loan-to-value ratio is one such restriction that these savings and loan associations are required to follow. However, there are no such restrictions on the National Bank’s real estate lending activities. The paper discusses whether the National bank should also be subjected to such restrictions.
- • Do loan–to–value ratio regulation changes affect Canadian mortgage credit?, Kronick, J. (2015). The paper analyzes how the residential mortgage credit was affected by the loan-to-value ratios in the Canadian housing market from 1981 to 2012. It attempts to determine if the LTV ratio regulation if effective in slowing down the potentially overheated Canadian housing market. The study employs structural vector autoregression (“SVAR”) to find the result. The study finds two types of impact of the four major LTV regulation changes that occurred in that period. Either they didn’t have much effect on mortgage credit, or they affected the mortgage credit in a way which was not expected. Only the tightening of LTV that happened in 2008 has had a minor effect though. The paper concludes that the overheated housing market in Canada cannot be slowed down by regulation changes.
- • Loan–To–Value Ratio As A Macro-Prudential Tool–Hong Kong Experiences, Wong, E., & Hui, C. H. (2010). Loan-To-Value Ratio As A Macro-Prudential Tool–Hong Kong Experiences. mimeo, Research Department, Hong Kong Monetary Authority. The study attempts to examine the effectiveness and shortcomings of maximum loan-to-value ratios as a macroprudential tool. The evaluation is done based on the experience of Hongkong and econometric analyses of panel data from 13 economies. The study finds the maximum loan-to-value ratio to be an effective tool in reducing the systemic risk caused by the boom-and-bust cycle of property markets. However, the study also finds a drawback of this tool. It shows the tool could impose higher liquidity constraints on the borrowers. The paper concludes the mortgage insurance programs can overcome this drawback without undermining its effectiveness.
- • Study on Loan–to–value Ratio of Logistics Financing Base on Purchasing Execution, J, Song, R., & Du, J. (2012). Logistics Technology, 19, 047. The paper analyzes the structure of logistics financing innovated mode based on purchasing execution and discusses the role and function of the stakeholders. This mode is then compared with other logistics financing modes.
- • Determining pledged loan–to–value ratio: an option pricing perspective. Zhang, R., Zhang, J., & Xu, S. (2015). Financial Innovation, 1(1), 16. The paper analyzes the pledged loan-to-value ratio in the option pricing perspective assuming that the interest rate is fixed, and the loan is without a coupon. The analysis shows the term, excess return and the value volatility of the pledge decides the pledged loan-to-value ratio. The same work is then extended to loans with coupon and portfolio pledge scenarios. Numerical analysis is done for loans without a coupon and fixed interest rate scenarios.