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Understanding Loan-to-Value (LTV) Ratio

If you are taking a home loan or a gold loan, the one factor you would get to hear is the loan to value ratio or the LTV ratio. This is a popular tool or ratio that lenders use and there are some restrictions on this ratio placed by the RBI to protect the interests of the bank. This loan to value ratio will determine how much financing you can avail from your selected lender. This is normally measured as a percentage of the market value of the asset being mortgaged or hypothecated. LTV ratio is not relevant for unsecured loans but only for loans that are secured by underlying assets like home loans, gold loans, car loans etc.

Deciphering the concept of loan to value ratio

The loan to value ratio or the LTV ratio, is an important facilitating tool for lenders and also gives the borrowers an idea of how much loan they can avail. The LTV ratio measures the ratio of the loan amount to the value of the loan collateral that is pledged, hypothecated, or mortgaged. In the case of a gold loan, it is the ratio of the gold loan to the value of gold at current market prices, subject to traditional haircut. For example, when a gold is made available at 75% LTV, it is not exactly 75% of the market value of gold, but it is 75% of the market value of gold adjusted for quality, costs etc. In the case of a home loan, which is the subject matter here, the LTV ratio is the percentage of the loan as a share of property value that a lender is willing to finance via loan. For the lenders, a higher LTV ratio is synonymous with higher risk while a lower LTV ratio is synonymous with lower risk.

Calculation of the LTV ratio

The calculation of the loan to value ratio or the LTV ratio is relatively simple. You can apply the formula give below.

LTV Ratio = Loan Amount / Appraised Value of Collateral.

For example, if the property identified by you has an assessed market value of Rs. 1 crore and the bank is willing to fund up to Rs. 82 lakhs, then your loan to value ratio is 82%. However, in reality, the assessable property is not just the market value of the property but comes with a number of adjustments and therefore the actual LTV ratio that you get would be lesser than the LTV ratio that the bank or lender claims.

When it comes to home loans, the RBI has issued some broad guidelines with respect to loan to value ratio or LTV ratio. As per extant RBI norms, LTV ratio can go up to 90% for home loans to Rs30 lakhs and it can go up to 80% for loans between Rs30 lakhs and Rs75 lakhs. However, for loans above Rs75 lakhs, the LTV ratio would be restricted to 75% of the assessable value of the property only. The idea is not just protecting the risk of the lender, but also to ensure that borrowers have skin in the game and don’t end up with negative home equity if the property value goes down subsequently.

How good is a higher loan to value ratio?

Borrowers often ask, what is the ideal loan to value ratio or LTV ratio. There is no such thing, but let us look at the merits and demerits of a high LTV ratio. First the merits.

  • Enables you to get a higher funding for the property
  • Allows you to seek properties in a better locality and better amenities
  • Higher LTV leaves more of your own resources for other purposes.

However, a high LTV ratio also has certain downside risks.

  • Normally, higher LTV ratio means you are paying more EMI each month
  • Higher LTV ratio may entail higher interest rates or longer tenure. Either ways, you end up paying higher interest cost over the home loan tenure
  • If property prices fall, then high LTV ratio can result in negative home equity
  • High LTV ratio, at times, can coax you to borrow beyond your means
  • A home loan is about negotiations. A high LTV ratio, restricts your bargaining power with the borrower

So, what is the answer to this question?

Borrowers must approach the LTV riddle rationally

The moral of the story in any home loan is to pay as much upfront as you can. Even if the bank offers you 90% LTV ratio and you can afford to take the LTV ratio to 75%, that is exactly what you should do. When you have a lower loan amount, you can lower your tenure or even prepay the loan earlier and the home becomes entirely yours. Lower debt is never a bad thing. It always adds more value to your net assets in the long run.

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