Loan to Value Ratio Explained & Why You Should Care

I'm Doug Hoyes, and on this Debt Free in 30 personal finance explainer video, we're talking about loan-to-value ratio. Why? Because lenders use it to decide if they will give you the loan, so it's important that you understand before you apply for a loan how it works. A loan-to-value ratio, also known as an LTV ratio, is a simple calculation that compares the amount of the loan you're taking out with the value of the asset you're buying with that loan. For example, let's say you're buying a house worth $1,000,000 and have 20% for a down payment, or $200,000. You'll need to take out a loan for $800,000 to buy the house, which means your loan is 80% of the value of the house. To calculate the loan-to-value ratio, I took $800,000 and divided it by $1,000,000. That's 0.8 or 80%. In this case, your loan-to-value ratio is 80%. If you added $20,000 more debt to the property, perhaps to refinance some credit card debt through a second mortgage or home equity line of credit, you now have an LTV ratio of 82%. A loan-to-value ratio is used for several types of secured loans, including home and auto loans. These are loans where repayment is secured by the value of the asset you're buying. Why does this matter? Lenders use this ratio to decide how risky it is to give you a loan. If you default or stop making payments on a secured loan, like a mortgage or car loan, the lender can seize the asset and sell it to recover what is owed to them. If the loan-to-value ratio is high, there's a risk they might not recover the amount remaining on the loan when they sell the property, especially if there's a lot of accumulated penalties, interest, and legal fees. Lenders may charge you a higher interest rate on a high LTV loan to protect themselves in case you can't pay back the loan. It's also important to note that certain types of loans, such as mortgages, often have minimum LTV ratios set by lenders. Private lenders might be willing to give you a high LTV loan, say a 95% mortgage, but the interest rate will be very high. A high LTV loan also means it will take you longer to build equity in your asset, and since you have a larger loan, you're paying more in interest than if you have a bigger down payment. Another concern is a falling real estate market. Falling house prices can mean a higher LTV if and when you need to refinance, increasing your potential interest rate. Knowing your loan-to-value ratio is important for both borrowers and lenders when it comes to assessing risk, determining loan terms, and making informed decisions when it comes to your finances.