What is a loan-to-value ratio and how do investors use it?
A loan investor should always consider what’s known as the loan-to-value ratio (LTV) to assess the risk behind the investment. Understanding the ins and outs of this important metric and its impact on loan terms can be beneficial when evaluating a range of investment classes including real estate, art and private credit.
LTV is defined as the ratio of the loan amount to the value of the underlying asset. By comparing the two values, lenders are in effect evaluating how much collateral coverage their loan has. In other words, the lenders are evaluating the risk on the likelihood that the proceeds from the sale of the collateral will be adequate to cover the outstanding principal and accrued interest, if the lender has to sell the collateral to recoup the investment.
How to calculate LTV ratio
Calculating LTV is fairly simple: the loan amount is divided by the total value of the underlying asset. The decimal is then converted into a percentage by multiplying by 100. For instance, if you intend to finance a borrower’s purchase of a property valued at $500,000, and your loan amount is $400,000 then you simply divide this loan amount ($400,000) by the property value ($500,000). The LTV in this case is 80%.
LTV = Loan Amount / Asset Value
An important note to consider is that the asset value can be based on an appraised value of the underlying asset or value from another source.
How do investors use the LTV ratio?
Many investors may first be introduced to the term LTV while in the market for a residential mortgage, but the ratio is used for loans with a variety of collateral-types. The ideal LTV ratio therefore, is largely dependent upon the asset class and the collateral type associated with it.
Why is the LTV ratio important?
Because a lender uses the LTV ratio to determine the riskiness of a loan, interest rates also correlate to LTV ratios. Lenders will typically charge a higher interest rate when assessing a high LTV situation because of the increased risk they are assuming. If a lender ever has to sell the asset to recoup their principal and interest, as in the case of default or foreclosure by the borrower, high LTV ratios carry an increased likelihood that the proceeds of the sale of collateral may not be enough to cover the outstanding accrued interest and principal loan balance. Therefore the loan is deemed riskier, and carries a higher interest rate.
A lower LTV provides a greater “cushion” for the lender in case the lender has to foreclose on the loan. LTV is one of many tools Yieldstreet uses when evaluating a borrower’s loan proposal.
What else should investors consider?
When using the LTV ratio, investors should be also aware of these other points.
Market Volatility: The market can be like a rollercoaster, and this definitely affects LTV. If the value of an asset, like a house or a painting, goes up or down, that changes the LTV ratio.
Reappraisal and Refinancing: Suppose a property is reappraised and its value changes. Or maybe the borrower wants to refinance. Both scenarios can change the LTV ratio.
Regulation: Some jurisdictions impose a cap on the LTV ratio that lenders can offer. Understanding these restrictions could also help to further assess the risks associated with the loan.
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