Why loan to value ratio’s matter

January 18, 2021

When looking at secured loans you will often see reference to the Loan to Value ratio;often referred to as the LTV. In this blog we will look at how the LTV iscalculated, what it means and why it matters.

How to calculate the LTV

The formula to calculate the LTV is quite simple. You dividethe value of the loan by the value of the collateral used to secure the loan. For example,if your outstanding mortgage is £150,000 and your house is worth £200,000 youwould have an LTV of:

               LTV =loan/collateral

               LTV = £150,000/ £200,000

               LTV = 75%.

If you are buying your first house the LTV is equal to 100%minus your deposit. E.g. if you have a 10% deposit your LTV is 90% (100% - 10%deposit)

What does the LTV mean?

If you fail to make payments on a secured loan, the lendercan take possession of it and then sell the collateral to cover the outstandingloan. In the example above the mortgage had an LTV of 75%. This means that ifthey repossessed the house, they would be able to cover the outstandingmortgage with room to spare.

But house prices are not constant. In the UK house priceshave tended to rise, but during recessions house prices can drop. In theexample above the house price would need to drop by 25% (£50,000) for thelender to not get their money back.

Imagine a different situation. Your neighbour’s house is alsoworth £200,000, but they have a mortgage of £190,000. This would give them anLTV of 95% (£190,000/£200,000). House prices would only have to drop a littleover 5% (£10,000) for the lender to lose money!

It is much more likely that house prices drop 5% than 25%. So,you neighbour’s mortgage is higher risk than yours.

Why does the LTV matter?

The lower your LTV, the safer your loan is for the lender.This means that they can charge you a lower interest rate. If you look atmortgage rates, you will see that lenders offer lower rates to people withlower LTV’s. The lower the interest rate, the less the loan costs you.

Lower LTV’s mean cheaper loans.