What is LTV in a home loan and why is it important? – Advisor Forbes INDIA
One of the biggest concerns for a buyer is the down payment for a home. Even paying a small percentage of the property’s value can have a huge impact on your borrowing power and the overall cost of the loan.
The initial down payment plays a crucial role in eligibility for a home loan, so knowing what loan-to-value or LTV means and how it affects you as a borrower is essential.
What does LTV mean?
LTV is a ratio commonly used by lenders to assess the risk associated with any loan opportunity. A high LTV means that the loan amount you borrow is more than the required home loan, and lenders could lose more if they default on their payments. A lower LTV implies that you can put more money towards the purchase of your home. This is considered a good indicator for analyzing your loan repayment options and the possibilities of future defaults.
To explain the concept in terms of derived monetary value, the LTV ratio can be defined as the amount you get after dividing the loan amount by the total value of the property.
LTV ratio = Amount borrowed / property value x 100
For the bank, the ratio is used to decide how much loan it would disburse.
For example, let’s say the house you are planning to buy is worth INR 2 crore and you plan to put down a 15% down payment or INR 30 lakh. This means that you would need an INR 1.7 crore loan, which is not covered by your down payment. So if 15% is the deposit then the LTV will be 85%.
As a loan with a higher LTV is considered riskier, banks generally encourage a healthy LTV ratio of up to 80%. However, some banks may even grant loans on an LTV ratio of 90%, depending on the prevailing economic scenario and your creditworthiness.
The central banking authority, the Reserve Bank of India, usually sets a maximum LTV criterion for various categories of loans. For loans up to INR 30 lakh, the maximum LTV allowed is 90%. For loans with a value between 30 and 75 lakh INR, the authorized LTV is 80% and for loans above 75 lakh INR it is 75%. Based on this example, the bank will only lend 75% of the cost of the house, which means you will need to hold more funds and lower your LTV or switch to another lender who has a higher LTV.
Why is the LTV ratio important?
When evaluating a loan opportunity, the LTV ratio becomes an important metric to assess the risk profile of the borrower. It is generally considered high when the desired loan amount is equal to or close to the appraised value of the asset. Here’s how the LTV ratio impacts borrowers and financial institutions:
Higher interest rate: The interest rate offered on home loans plays a vital role for a person who decides the amount of their down payment and hence the LTV. The higher the LTV ratio, the higher the interest rate will be. Indeed, a higher LTV ratio is considered relatively risky. Therefore, lower the LTV, the lower your monthly payments (EMI) and reduce the pressure on your household budget during the term of the mortgage.
This is why it makes sense to make a larger down payment rather than opting for a higher interest rate. If you have sufficient funds that can be used to make an initial down payment, it will reduce your LTV. In this case, you will save on interest and IMEs and also shorten your tenure. However, if you can’t afford a larger down payment, save more for a larger down payment, or you can apply for a larger loan, which means a higher LTV ratio.
Higher LTV = Mortgage Loan Insurance: A higher LTV ratio also has implications for the potential cost of other necessary products and services. Typically, a large loan amount also comes at an additional cost for your home insurance. The cost of the additional insurance can be between 0.5 and 1% of the total loan amount on an annual basis. While the cost can also vary based on a variety of factors, adding an insurance premium to your monthly payments will usually increase your overall monthly EMI.
Insurance is a protection tool for the lender, as well as for yourself, in the event that you are unable to repay the loan in the event of an unfortunate event or otherwise. The Covid-19 pandemic is a prime example of how there are sometimes events beyond our control that can impact our regular income. Borrowers who can afford a larger down payment should go, as it saves them money on mortgage loan insurance.
Home loan approval: Few of the defined parameters assess a borrower’s mortgage eligibility. These factors include gross monthly income, loan term, existing monthly obligations, and LTV ratios.
Each lender makes sure to assess the level of risk. The riskier your appraised loan, the more difficult it becomes to get approved. From a lender’s perspective, when homebuyers invest more of their funds up front, they are considered financially prudent borrowers. For example, if you put INR 20 lakh on a house valued at INR 1 crore, your LTV on an INR 80 lakh loan will be 80%. The higher your down payment, the lower your LTV.
Home loan refinancing: The value of your home can appreciate over time. For the same, there is an option to refinance your loan. Refinancing means getting a new home loan from another lender or supplementing the existing one. The main reasons for refinancing are to benefit from a lower interest rate or to benefit from a supplement on the initial amount.
Whenever a borrower decides to refinance their home loan, LTV ratios are extremely important. It is a tool that is used by lenders to decide the credibility of a borrower. An LTV of 80% or less will allow you to benefit from better terms and lower interest rates. When it comes to refinancing, the LTV is always based on the appraised value of the home, not the original price.
Establish the equity in your home: Home equity is usually the part of your property that you âownâ. With the down payment, you get an interest in the property, as opposed to the lenders. Home equity is the most valuable asset for many homeowners that can be used later in different situations. And as you pay off your monthly IMEs, your home equity increases. As we said, someone with more property is less likely to fall behind on payments because they have a larger equity stake.
The LTV plays a major role in determining the net worth of your assets. A higher LTV ratio indicates that you have less equity in the asset. However, if you make a larger down payment, it can help increase the equity in your home.
What is a good LTV ratio?
Funded assets are important in deciding what constitutes a good LTV. This means that your LTV ratio requirement will depend on the loan you are looking for. However, when it comes to LTV ratios, it is always suggested to go lower. This can help you get better terms and lower interest charges.
While 80% LTV is generally considered good from a lender’s perspective, however, to lower their monthly payments or benefit from better interest rates, homeowners may want even more LTV. On the flip side, higher LTV ratios could be beneficial for someone looking to buy a home earlier and move up the real estate ladder.
In short, it all depends on your home buying goals and your future payment capabilities. A high LTV can have stressful financial implications for some borrowers, however, a lower LTV is still likely to put you in a better financial position where you can save and be stress free.
In short, it all depends on your buying goals and future payment capabilities. A high LTV can have stressful financial implications for some borrowers, however, a lower LTV is still likely to put you in a better financial position where you can save and be stress free.
Tips for lowering your LTV
LTV plays an important role when applying for a home loan because it can help you lower your IMEs and save you money over the entire term of your loan. Here’s how you can reduce it:
- Save for a larger down payment: If it turns out that you can’t make a reasonable down payment, you might consider taking a step back and not rushing into buying a home. Wait until you have saved more, as this will help you get a lower interest rate on your loan. This doesn’t mean that you are giving up on your dream of buying a home, but actually taking a little extra time to save for a bigger down payment.
- Choose a cheap house: If you can’t find a bigger down payment, maybe it’s time to shop around and aim for more affordable goals. Buying a cheaper home means you’ll have to borrow less money, which can lower your LTV. You may have to give up your dream home, but doing so will allow your current savings to make up a larger portion of the purchase price.
For example, one house is worth 2 cr INR and another 1.5 cr and you are ready to put 30 lakh INR as a down payment. If you go for the first house, your LTV will be 85%, however, if you were to buy the second house, your LTV will be 80%, which makes more sense.
Whenever you apply for a home loan, it’s important to understand the implications that a high LTV will have on your loan. Understanding this will put you in a better financial position and save money over the life of the loan. However, remember that the LTV is only part of your loan application. There are other factors that lenders take into account, such as your income, credit scores, and unpaid debts when approving a borrower.