As a potential home-buyer, there are many factors you need to consider before you buy your new home. This includes the tax policies, insurance policies and the cost of running the home. But one of the most important things you need to think about is how you will finance the purchase. This could either be through savings or through a home-loan from the bank.
If you decide to take out a loan to buy your home, there are numerous metrics that come into play when assessing the value of the loan. The most important one is the loan-to-value (LTV) ratio.
What is the loan-to-value ratio?
In its simplest terms, the loan to value ratio is the total size of the loan you need to borrow from the bank in comparison to the proportion of the value of the home that you can finance with this loan. This is a common metric used by many financial institutions to assess the level of risk involved in lending the money the home-buyer. This calculation also helps determine that the value of the money loaned by the bank is not higher than the value of the home. A high value LTV ratio means that the borrower is unlikely to payback the loan in full. This is why many financial institutions use it as an assessment metric when approving loans.
How do you calculate the LTV ratio?
The loan-to-value ratio is calculated as follows:
LTV = Total amount of the loan / Total value of asset (home)
You want to buy a home that is worth Rs. 2,00,000 but you only have Rs. 30,000 for the down payment. You would need to borrow the remaining Rs. 170,000 from the bank. The LTV ratio in this instance would be:
= 170,000 / 200,000 = 85%
What is a good LTV ratio?
In the example above, the loan to value ratio for our imaginary home would be 80%. But what do banks consider a good ratio in order to secure a loan?
1. Conventional homebuyers- For many conventional home buyers a ratio of 80% is standard. In the example above, since we have paid off at least 15% of the amount upfront, the bank would not consider it an optimal LTV ratio for the loan approval.
2. Other circumstances- In some cases where the home-buyer is taking out a loan that is below 30 lakhs, the LTV ratio can be higher at around 90%.
If your LTV ratio is too high, the bank will expect you to pay a higher down payment. Many banks have different criteria when it comes to a home loan, some banks may charge a higher interest rate if the LTV is too high. In this case, it is better to accept the higher interest rate instead of making a higher down payment.
Why is the LTV ratio important?
As discussed earlier, the main purpose of the LTV ratio is for the lender to evaluate the risk of the loan. A high LTV ratio means that lenders will be less inclined to give out the loan. The ratio is important for the following reasons:
1. The interest rate
One way lenders reduce the risk of lending out money to homebuyers is with interest rates. The higher the risk, the higher the interest rate. Therefore if the LTV ratio is high, the bank is likely to charge a high interest rate on the loan.
2. High insurance costs
A risky loan invariably increases the amount of insurance you need to pay since a large portion of your home is financed through loans. You may also need to purchase additional insurance policies to offset the riskiness of the loan.
The LTV ratio lets the financial institution know the true value of your loan and assess the possibility of a full loan repayment. Having a higher down payment lets the bank know that you have some skin in the game. It assures them that you will pay back the loan in full since you have your personal money invested in the asset.
The LTV ratio guidelines in accordance with the Reserve Bank of India
There are fixed guidelines when it comes to the loan-to-value ratio in India set by the RBI. For home loans that are below 30 lakhs, the LTV ratio value can be up to 90% of the total home value. In this case, the down payment for the home will be 10%. For a home loan that is between 30 and 75 lakhs, the LTV ratios to be 80% or lower. Since the loan value is higher, the down payment needs to be high as well. Any loan above 75 lakhs needs to have an LTV value of 75%.
If the LTV ratio falls within a bracket of between 75-90%, the lender will be sufficiently protected if the buyer is not able to pay the monthly payments on the loan in the future.
The lower the better
A low LTV ratio is good news for the borrower as it affects the other terms of the loan as well such as the interest rates and the insurance policies. If your LTV ratio is low, it puts you in a better position to negotiate your interest rate and insurance payments. If the homebuyer spends more of their money to make a down payment, the level of risk for the lender is much lower. As a first-time homebuyer it is important to conduct a cost-benefit analysis to decide whether it would be more optimal to accept the high LTV or make a higher down payment.
Other factors considered when evaluating LTV
1. Credit history- This is one of the most important factors banks look at when determining your eligibility for a loan. If you have a history of not making monthly payments on your loan on time, it could affect your credit score. If you have a good credit score, the bank can possibly lower your LTV.
2. Current debt- The total amount of liabilities you currently have can affect your loan eligibility. If you are in a lot of debt, the bank is unlikely to approve your loan.
3. Age- For many banks, you can only repay the loan until the age of 60. Hence, if you take out a loan at 50, you will only have 10 years to repay the loan. In this case, if your LTV ratio is above the recommended guidelines, the bank will be unlikely to approve the loan.
The LTV ratio is an important metric in determining the level of risk the lender faces when lending money. As a homebuyer, you also need to look at this value when calculating the down payment on the home. A high down payment means a low LTV and therefore lower interest rates but a high LTV ratio means a lower down payment and higher interest rates. As a borrower, it is advisable to keep the LTV ratio at its lowest.
Investing in a home is a big step so make sure you carefully assess all your options before taking the leap. Visit Shriram Properties for versatile homes that will help you make the best investment decision.
