What it means
Every secured loan has an asset behind it, whether a house, a vehicle or a warehouse. The loan-to-value ratio compares the loan with the value of that asset, and the maximum loan-to-value ratio is the ceiling a lender sets for it.
A lower ceiling means a bigger deposit for the borrower and a smaller risk for the lender. Lenders set the ceiling according to how risky and how easy to sell the asset is.
A prime residential property might carry a high ceiling, while a specialist building or a used machine might carry a much lower one. Regulators may also impose limits to stop the whole banking system becoming over-exposed to property prices.
For a borrower, the maximum ratio decides how much cash you need up front. At a ceiling of 75% on a purchase of $800,000, you must bring at least $200,000 yourself.
Many borrowers also find that lenders charge a higher interest rate, or require insurance, when the ratio is near the ceiling. An important nuance is which value the ratio uses.
Lenders normally take the lower of the purchase price and their own independent valuation, so a buyer who overpays can find the loan is smaller than expected. Values can also move after the loan is made, which is why the ratio is monitored for the life of the loan in some lending types.
Finance teams use the same idea in asset-based lending and in covenants. A covenant is a promise in the loan agreement, and a breach occurs if the ratio rises above the agreed ceiling, for example after the pledged assets lose value.
Borrowers can sometimes work around a low ceiling by offering extra security, such as a second property or a personal guarantee. The lender then looks at the combined value of everything pledged, which can lift the amount available without changing the headline ratio.
Each added layer of security also adds risk for the borrower, who may lose more than the asset being bought if repayments are missed.
In practice
Real-world examples.
Example
A couple buys a house valued at $600,000 with a lender whose maximum loan-to-value ratio is 80%. The most they can borrow is $480,000, so they need a $120,000 deposit. They decide to wait a year to save more before applying.
Example
A manufacturer takes an asset-based loan secured on inventory. The lender allows a maximum of 50% of the stock's value, so $2,000,000 of goods supports a loan of up to $1,000,000. The lender sets the low figure because stock can be hard to sell quickly.
Example
A property investor refinances a flat that has risen in value from $300,000 to $360,000. With a ceiling of 70%, the investor can borrow up to $252,000 and take out cash if the existing loan is smaller. The ceiling, not the rising price, controls how much equity is released.
Formula
Calculation
Loan-to-value ratio = Loan amount / Asset value
Maximum loan = Asset value x Maximum loan-to-value ratio
Suppose a company wants to buy a building valued at $500,000, and the lender's maximum loan-to-value ratio is 75%. The maximum loan is 500,000 x 0.75 = $375,000, so the company must provide $125,000 itself. If the company in fact borrows $350,000, its ratio is 350,000 / 500,000 = 0.70, or 70%, which sits within the ceiling.Case study
Seen in the real world.
Meridian Storage Partners is an illustrative, fictional company that owns self-storage buildings. Its loan agreement set a maximum loan-to-value ratio of 65% and required a revaluation every two years.
When the revaluation arrived, the portfolio's value had fallen from $20,000,000 to $17,000,000 after a local downturn. The outstanding loan of $12,000,000 now stood at 70.6% of value, above the ceiling.
Meridian had to repay $950,000 within sixty days to bring the ratio back to 65%, since 65% of $17,000,000 is $11,050,000. This illustrative case shows why the maximum ratio is a continuing obligation and not just a one-off test at drawdown.
Watch out
Common mistakes.
- Confusing the maximum loan-to-value ratio with the actual ratio, when the maximum is the lender's limit and the actual is what your own loan produces.
- Using the purchase price as the asset value, when the lender may use the lower independent valuation and shrink the loan.
- Ignoring that the ratio can worsen after the loan is made, because a fall in the asset's value pushes the ratio up even if you repay on time.
Questions
People also ask.
Why do lenders cap the ratio?
They want the borrower's own equity to absorb the first losses if the asset has to be sold, so the loan is still repaid in full.
Is a lower ratio always better for the borrower?
A lower ratio usually brings cheaper borrowing, but it also ties up more of the borrower's cash in the asset.
Does the maximum ratio differ by asset type?
Yes, lenders allow higher ratios on assets that are easy to value and sell, and lower ratios on specialist or volatile assets.
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