If you’ve ever applied for a car loan, you may have heard the term “Loan-To-Value Ratio” before. But do you know what that even means? If not, that’s okay. You’re not alone.
Car buyers often report being confused by the terms used by financial lenders. Let’s be honest, the dealerships aren’t exempt either. There are a lot of puzzle pieces involved with applying for a car loan, each with their own set of tricky vernacular.
So today, we’ll clear up any confusion you might have about loan-to-value ratios. We’ll also answer the following questions:
- Why do lenders bother calculate loan-to-value ratios?
- How does a down payment affect an loan-to-valueratio?
- What’s the difference between a good and bad loan-to-value ratio?
First, though, let’s explain what an loan-to-value ratio is.
What is a Loan-To-Value Ratio?
A loan to value (LTV) ratio is a measure of risk. It helps a lender determine how “risky” it is to lend to you and whether or not they should assume that risk. Simply put, it lets lenders know how much of a loan is backed up by tangible, real world value.
An LTV ratio is expressed as a percentage, which is calculated by the amount of the loan you’re asking for, divided by the value of your car.
So if you’re looking to buy a $30,000 vehicle and you apply for a loan of $30,000, your LTV is 100%. If you want to buy that same car, but instead ask for a loan of $35,000, your LTV is 125%.
Why Do Lenders Calculate Loan-to-Value Ratios?
With most loans, lenders usually ask for some type of collateral before they approve someone, just in case the borrower can no longer pay the loan back. That way, the lenders aren’t out any money.
With auto loans, the car is the collateral. So if a borrower can’t pay their loan back, the lender will repossess the vehicle in order to recover their money. In some situations, though, it isn’t always that straightforward.
Sometimes people ask for a loan that is for more than the value of the car they plan on buying. There are a bunch of difference reasons for doing this.
- The extra money can pay off other loans with higher interest rates.
- It is an opportunity to consolidate other debts into one loan.
- You can use the extra money to make modifications to the new vehicle, i.e. a remote starter.
This means that lenders often lend out more money than they have collateral for.
More often than not, lenders are willing to extend loans like this. However, once an LTV ratio gets too high, for example if the loan far exceeds the value of the car, lenders become less likely to approve you for a loan.
Lenders calculate LTV ratios so they can make sure the gap between the car’s value and the loan is never too big.
How Does a Down Payment Affect an LTV Ratio?
Obviously, the more money you put towards a vehicle, the better. It translates into a smaller loan, usually over a shorter period of time and will eventually cost you less in interest.
But another great reason to make a down payment and that is that it lowers your LTV ratio.
Here’s an example.
Sam and Mary want to buy a $20,000 car. They’ve decided to have a remote starter installed, too. On top of that, they also want to finance an additional $3,000 from a previous loan into the total purchase. When everything is added up, Sam and Mary are asking for a $24,500 loan.
That means their LTV is 122.5%, so the lender would be assuming a 22.5% financial risk. Now, some lenders would have no problem with an LTV this high. Others, however, might. It depends on the lender.
But if the LTV ratio you’re asking for is too high, you can either ask for less money or make a down payment.