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 is calculated, what it means and why it matters.
How to calculate the LTV
The formula to calculate the LTV is quite simple. You divide the 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 you would 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 lender can take possession of it and then sell the collateral to cover the outstanding loan. In the example above the mortgage had an LTV of 75%. This means that if they repossessed the house, they would be able to cover the outstanding mortgage with room to spare.
But house prices are not constant. In the UK house prices have tended to rise, but during recessions house prices can drop. In the example above the house price would need to drop by 25% (£50,000) for the lender to not get their money back.
Imagine a different situation. Your neighbour’s house is also worth £200,000, but they have a mortgage of £190,000. This would give them an LTV of 95% (£190,000/£200,000). House prices would only have to drop a little over 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 at mortgage rates, you will see that lenders offer lower rates to people with lower LTV’s. The lower the interest rate, the less the loan costs you.
Lower LTV’s mean cheaper loans.
