Learn Why Lenders Calculate Loan To Value Ratios for Car Loans
A loan to value ratio, or LTV, is simply the ratio of a loan amount to the market value of the asset to be purchased with the loan. LTV is a measure of risk. It describes how much of a loan is backed up by real world value.
How to Calculate LTV for a Car Loan
Your LTV for your car loan is simply the ratio of your loan amount to the market value of your car.
LTVs are usually expressed in percentages. So, if you borrow $20,000 to buy a $20,000 car, your LTV will be 100% [100% = $20,000/$20,000]. And if you need to borrow $25,000 to buy a $20,000 car for some reason, your LTV will be 125% [125% = $25,000/$20,000].
You can find the market value of your car using car value estimation services from companies like Edmund’s or Kelley Blue Book.
Why Do Lenders Calculate LTV for Car Loans?
When a lender loans out money, it does so with the expectation that its borrowers will pay it back. However, some borrowers inevitably will default on their loans, creating risk for a lender every time it makes a loan.
To protect itself, a lender may require collateral (an asset that acts as security of repayment) on each of its loans. Usually, for auto and home loans, the collateral is the car or house itself.
If a borrower defaults on his/her loan, the lender can repossess the collateral to recover its losses. It may seem like collateral eliminates a lender’s loan risk entirely because one way or the other it can recover its money. However, borrowers regularly borrow more than they need to purchase their cars and homes for various reasons – such as to finance protection products into their loans or to roll negative equity (or debt from a previous loan) in to their new loans. The result is that lenders oftentimes find themselves lending more money through loans than they have collateral on their loans.
By setting maximum LTVs for loans, lenders ensure that they never expose themselves to too much risk.
The Effect of a Downpayment on LTV
The easiest way to reduce a LTV is to borrow less money. If you are set on purchasing or refinancing a specific car, but your LTV is too high to receive an approval, then your lender may ask you for a down payment that will reduce the amount of money you need to borrow, bringing down your LTV.
Example: Loan-to-Value of a Car Loan
Suppose you want to buy a car worth $15,000, but that you have to finance $2,000 of negative equity (i.e. debt from a previous loan) into your purchase. Additionally, you would like to purchase a service protection product for $500. You will need to borrow not just the $15,000 for your car, but an extra $2,500 for your negative equity and your protection product, making the total loan amount you are seeking $17,500.
For your loan, your LTV will be 116.67% [116.67% = $17,500/$15,000], meaning you need a lender that will make loans that high, which many do. And if you were to default on this loan – not that you would –, your lender would only recover the market value of your car at the time of your default when it repossesses the car. So, the 16.67% extra loan amount on top of your car value is risky for your lender.
Now let’s pretend that a lender is willing to give you a loan, but only at an LTV of 110%. If you decide to go with this lender, you will have to make a down payment. You can bring your LTV down to a 110% LTV buy making a down payment of $1,000 because a loan of $16,500 [$16,500 = $17,500 – $1,000] with a car worth $15,000 will result in an LTV of 110% [110% = $16,500/$15,000].