What Is Loan-to-Value Ratio?
Small business owners may need a home loan for a variety of reasons—like when using real estate as collateral for a business loan or when buying commercial real estate. A loan-to-value ratio plays an important role in whether or not that loan gets approved, with lenders using this measurement to help determine the loan’s risk.
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What you need to know about loan-to-value ratios
Lenders use loan-to-value ratios to determine the amount of risk involved in a secured loan, such as a mortgage or home equity loan. The ratio compares the amount of money owed on a loan to the current appraised value of a property.
Simply put, the LTV ratio is the amount leftover after a down payment. So a 10% down payment would have a 90% LTV ratio, while a 5% down payment would have a 95% LTV ratio.
How loan-to-value ratios work
Loan-to-value ratios are just one tool lenders use to determine how risky a loan is, along with indicators like your credit score, monthly income, debt-to-income ratio, and the type of asset being purchased.
Small business owners with a good credit score will find it easier to obtain a high LTV loan, while those with a bad credit score may have a harder time. And though LTVs are most commonly associated with home loans, they are also used for auto loans and more. Other types of loans may have a higher LTV ratio in comparison to home loans.
Why small business owners should care about LTVs
LTV ratios may seem insignificant at a glance, but they can dramatically alter a small business owner’s monthly payments over the entire span of a loan. And for business owners with less access to capital, that difference could make or break the success of the company.
A lower LTV ratio results in lower monthly payments, while a higher LTV ratio can result in higher monthly payments and additional fees (like private mortgage insurance). A high LTV could also reduce the chances of getting a loan approved, meaning a small business owner could lose their chance at getting approved for a business loan, buying commercial real estate, or being able to grow their business at home.
How loan-to-value ratio affects interest rates
Most lenders in the US offer lower interest rates for loans they perceive to be less risky. And since a higher LTV ratio is seen as a greater risk for lenders, it typically means lenders raise interest rates for those with a high LTV (80% or higher).
How to calculate loan-to-value ratio
Loan-to-value ratio is calculated by dividing a loan amount by the appraised value of an asset. This number is multiplied by 100 and becomes a percentage:
(Loan amount / asset value) x 100 = LTV
For example, if a house has a value of $500,000 and the loan amount totals $400,000, the LTV ratio would be 80%, or ($400,000/$500,000) x 100.
Is it best to have a high or low loan-to-value ratio?
In most cases it is better for small business owners to have a lower loan-to-value ratio, since lenders consider a high LTV to be riskier. A lower LTV will reduce the total cost of the loan, while a higher LTV could result in higher monthly payments and additional monthly fees. Since lenders are typically stricter on approving business loans, it’s especially important for small business owners to have a low LTV.
What is a good loan-to-value ratio?
So what is a good loan-to-value ratio? When it comes to conventional mortgage loans or combined loans, a good LTV ratio is considered anything 80% or lower. When an LTV ratio falls above 80%, the person taking out the loan is typically required to pay private mortgage insurance (PMI), which can ultimately raise loan payments by thousands of dollars.
However, certain loans allow for very high LTV ratios without PMI or other penalties. A Federal Housing Administration (FHA) loan only requires a down payment of 3.5%, resulting in a LTV ratio of 96.5%. Similarly, veteran’s loans don’t require any amount of down payment, resulting in a LTV ratio of 100%.
Ways to lower loan-to-value ratio
Since a LTV ratio of 80% or lower typically leads to more favorable loan terms, many small business owners look for ways to lower their LTV ratio or reduce the difference between the amount owed on the loan and the value of the asset.
There are just a few ways to accomplish this:
- Put more money down. Making a larger down payment will make the loan less risky for the lender and eliminate the need for PMI.
- Pay down the loan’s principal. If you already have a home loan and want to raise your LTV, you can do so by making larger payments or more frequent payments to pay down your loan’s principal. Keep in mind—some loans have prepayment penalties, so you’ll want to ask your lender before you do this.
- Choose a lower cost asset. If a borrower cannot make a larger down payment, they can reduce their LTV ratio by choosing a lower-costing asset. This will increase the down payment percentage and consequently lower the LTV ratio.
Loan-to-value ratio FAQ
What is a loan-to-value ratio?
A loan-to-value ratio is a measurement lenders use to determine the risk of a secured loan. A high LTV ratio indicates that the borrower owes more on the loan, while a low LTV ratio indicates a higher down payment, meaning the borrower owes less on the loan.
Why is a loan-to-value ratio important?
Loan-to-value ratios are important to small business owners because they play a role in determining whether or not their loan gets approved. A high LTV ratio could prevent a business owner from being able to buy property, grow their business at home, or use their property as collateral for a business loan.
How is LTV calculated?
LTV is calculated by dividing the total loan amount by the asset value, then multiplying it by 100 to get a percentage: (Loan amount / asset value) x 100 = LTV
What does 60% LTV mean?
An LTV ratio of 60% means that a borrower owns 40% of an asset. For example, if a person gets a $150,000 loan for an asset worth $250,000, the resulting LTV ratio would be 60%.
What does 80% LTV mean?
When a borrower has an LTV ratio of 80%, it means they owe 80% on their loan in comparison to the appraised value of an asset. For example, if a borrower gets a $400,000 loan for an asset worth $500,000, the LTV ratio would be 80%.
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A loan-to-value ratio is an important measurement used by lenders to decide how risky a secured loan will be. An LTV of 80% or higher could result in higher interest rates or be less likely to be approved, meaning a lower LTV is more desirable. Small business owners can reduce this ratio by making a large down payment, paying down the loan’s principal at a faster rate, or by simply choosing a lower priced asset.
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