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Loan to Value Ratio

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Loan to Value Ratio

The formula for the loan to value ratio is the loan amount divided by the value of the collateral used for the loan. The formula for the loan to value ratio is most commonly referenced in auto loans and mortgages, but can be applied to any loan that is secured with collateral including boat loans, RV loans, and certain types of commercial loans.

The value of collateral in the denominator of the formula for the loan to value ratio can be found depending on what type of loan is involved. The value of collateral for mortgages, land, and commercial real estate is generally determined by an appraisal. Used car loans and other forms of used consumer loans are generally determined by the book value published by companies such as NADA and Kelley Blue Book. The MSRP, or manufacturer's suggested retail price, may be used with consumer loans that use a new product as collateral.

Use of Loan to Value Formula

The formula for the loan to value ratio is generally used by loan officers and underwriters as part of evaluating an applicant's qualifications. Lending institutions have guidelines to determine if a loan applicant qualifies for the loan requested. If the loan to value ratio on a particular loan request is outside of the lending institution's guidelines, a higher down payment may be required.

The formula for the loan to value ratio is also used specifically in mortgages to determine if private mortgage insurance, or PMI, is required. In many cases, PMI is required on a mortgage that has a higher loan to value ratio than 80%, but individual lender programs may vary.

The relevance of the loan to value ratio for a lending institution is evaluating the risk associated with a particular loan. Using collateral could be considered less risky of an investment than one that is unsecured such as a credit card. Banks rely on interest from their loan portfolios as one source of their income and, like other forms of investments, must evaluate the risk and return of that investment portfolio.

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