What is Loan-to-Value (LTV)?
The Loan-to-Value ratio, commonly referred to as LTV, shows how much of an asset’s value a lender is willing to finance through a loan. It’s usually expressed as a percentage and helps lenders measure the level of risk in a loan deal.
In general, the more “desirable” or stable an asset is, the higher the LTV a lender may offer. An asset’s desirability depends on factors like how steady its value is, how easy it is to sell in the secondary market, and how smoothly ownership can be transferred.
Key Points to Know About LTV
- LTV is a ratio that shows what percentage of an asset’s value is being covered by a loan.
- It’s calculated with the formula:
LTV (%) = (Loan Amount ÷ Asset Value) × 100 - Assets seen as safer or more valuable collateral often get higher LTVs.
- However, market trends and competition among lenders can also influence how high or low LTVs are.
- Different lenders may use different ways to determine the “value” part in LTV depending on the type of loan and asset involved.
How Do You Calculate LTV?
The basic LTV formula is simple, but the actual calculation can vary depending on the loan type or the lender’s approach. Here are a few examples:
1. Based on Minimum Equity Requirements (Example: Buying a Home)
In home loans, a lender may require you to contribute a certain minimum down payment—say, 5% of the property’s price. This means the lender would finance the remaining 95%. So, the maximum LTV would be 95% (100% – 5%).
2. Based on Risk Appetite (Example: Equipment Financing)
If a lender is financing used equipment for a business, they might assume the equipment’s resale value could drop by 25% during a forced sale. To protect themselves, they may offer a maximum LTV of 75% (100% – 25% risk buffer). This approach gives the lender a safety margin in case the asset has to be sold quickly.
3. Based on Cash Flow (Example: Commercial Real Estate)
Some lenders use the expected cash flow from a property to decide how much they’re willing to lend. They calculate how much net income (NOI) the property will generate, work backward using interest rates and debt repayment rules, and determine a present value.
That value becomes the maximum loan they’re willing to give. When you divide this loan amount by the current market value of the property and multiply by 100, you get the LTV.
Why is LTV So Important for Lenders?
Lenders make money by earning interest on loans. But if a borrower can’t repay, lenders face potential losses. This is where LTV comes in.
A lower LTV means the lender has a safety cushion. If the borrower defaults and the lender must sell the asset, there’s a better chance they’ll recover the full loan amount. High LTVs leave less room for error.
Also, when borrowers contribute their own money (often called “skin in the game”), they’re more likely to stay committed and repay the loan. Without this personal investment, a borrower might walk away from the loan if things go bad.
Loan-to-What?-Value: How “Value” is Determined
Not all lenders use the same method to figure out an asset’s value. There are three common approaches:
1. Book Value
This is the value recorded on a company’s balance sheet. For example, a business might use the book value of its unpaid invoices (accounts receivable) to secure a loan. However, for physical assets like machinery, book value can be misleading because it includes depreciation.
Depreciation is an accounting method and doesn’t always reflect an asset’s true market worth.
2. Purchase Price or Cost
This is often used when a business buys new equipment. The lender can easily verify the asset’s value using the invoice. But if the asset is used or was already owned, purchase price doesn’t help. In such cases, the lender will likely require an appraisal.
3. Appraised Value
An appraisal is done by a certified expert who estimates what an asset is worth in today’s market. This method is widely used for commercial property and equipment loans. There are typically three appraisal types used by lenders:
- FMV (Fair Market Value): The price the asset could sell for under normal market conditions.
- OLV (Orderly Liquidation Value): What the asset would likely fetch in a sale where time is limited but buyers are still informed.
- FLV (Forced Liquidation Value): A conservative estimate based on a rushed sale, often at auction, where the price is expected to be the lowest.
It’s important that lenders, clients, and risk officers all understand whether a loan is based on 75% of FMV, OLV, or FLV, as this directly affects how much can be borrowed.
What’s Considered a “Normal” LTV?
LTVs vary based on the asset type and how much risk a lender is willing to take:
- Cash as collateral: Often qualifies for 100% LTV since it’s risk-free.
- Residential real estate: Can go as high as 95%.
- Commercial property: Usually capped around 75% of the appraised value.
- Inventory: Typically gets much lower LTVs, around 50%, due to its unstable resale value.
- Rare personal assets (like artwork or collectible cars): Might only qualify for 25-30% LTV because they’re hard to resell and appeal to niche buyers.
How the Market Affects LTVs
While lenders would prefer to offer lower LTVs to reduce risk, they also have to compete for borrowers. If other lenders in the market are offering higher LTVs, a bank may need to adjust its policies to stay competitive.
For instance, in today’s fast-changing finance space—especially with fintechs and digital lenders rising—some institutions are willing to take on more risk to attract clients. As a result, market competition can drive LTVs higher than lenders would ideally prefer.
So, financial institutions must constantly strike a balance between offering attractive LTVs and protecting themselves from potential losses.
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