There are a lot of terms when it comes to getting a loan. But of all of the terms you may be unfamiliar with, loan-to-value ratio is an important term you should get to know.
Here’s what you need to know about loan-to-value ratios (and how to know if you have a good ratio).
What is loan-to-value?
A loan-to-value ratio compares the amount that you want to borrow to the value of the asset you are purchasing. Lenders look at loan-to-value ratios for all secured loans (such as car loans and mortgages). These ratios tell lenders how much of a risk the loan is.
Secured loans mean that there is collateral that ensures the loan. If you should default on payments, the lender has the right to physically take your collateral and sell it to recoup their losses. If your collateral is not worth as much as you owe, the lender will not be able to make back their money.
Loan-to-value ratios are calculated by dividing the amount of the loan by the appraised value of the asset.
LTV= Amount of Loan / Value of Asset
For example, let’s say you want to purchase a car that is $35,000. You are making a down payment of $7,000 and you will have to pay a 7% sales tax and $500 in fees. Your total loan amount will be as follows:
Car Price - Down Payment + Sales Tax + Fees = Loan Amount
$35,000 - $7,000 + $2,450 + $500 = $30,950
To calculate the loan to value ratio you divide that by the value of the asset.
LTV= Amount of Loan / Value of Asset
LTV= $30,950 / $35,000
How does LTV affect interest rates?
The lower your LTV is, the less of a risk your loan is. Lenders in the United States use what’s called “risk based pricing” when it comes to assessing interest rates. In other words, the riskier your loan is, the higher the interest rate will be. A loan can be designated as risky for any of the following reasons:
- You don’t have a good credit score
- You don’t have a good repayment history
- You don’t have a good employment history
- Your debt to income ratio is high
- Your loan term is too long
- Your down payment is not large enough
- The loan-to-value ratio on your vehicle is high
If your loan is viewed as risky, chances are you will be offered high interest rates.
How can a loan-to-value ratio be higher than 100?
So how can your total loan amount be for more than the price of the asset you are buying? There are a few ways that this can happen.
#1. You don’t pay anything upfront.
Not making a down payment puts you at a severe disadvantage from the start. Not only do you need to take a loan out for the total cost of the car, but you need to pay for the taxes and fees. This can easily add a few thousand dollars to your price tag. Let’s look at the above example, assuming there was no down payment.
Car Price + Sales Tax + Fees = Loan Amount
$35,000 + $2,450 + $500 = $37,950
LTV= Amount of Loan / Value of Asset
LTV= $37,950 / $35,000
Lenders do expect this to some extent, which is why you can typically get approved for a loan with up to a 125% loan-to-value ratio. Some lenders will even go above 125%.
#2. You have a car with a high rate of depreciation.
All cars depreciate at different rates. Depreciation is based on a number of factors, including:
- Your car make
- Your car model
- Your car year
- The mileage
- The paint color
- The wear and tear on your car
- And other factors
If your car depreciates at a faster rate, it is possible that your depreciation will outpace your payments (especially if you did not put down a down payment, or didn’t put down a large enough down payment). Your loan-to-value ratio changes throughout the course of your loan, so it is possible that your LTV can increase to an uncomfortably high level.
#3. You owe money on another car.
If you already have a car loan where you owe money, you may have the chance to roll that negative equity into your new car loan. So if you owe $5,000 on a previous loan, you may roll that into your new loan. Your new car may be $30,000, but you will have a loan for $35,000.
How do loan-to-value ratios affect refinance?
If your loan-to-value ratio is too high, you may have a harder time with a car loan refinance. But generally if your LTV is lower than 100% it is considered a good loan-to-value ratio and you will be able to refinance your car loan.
How to lower your loan-to-value ratio
There are a few tips to ensure that your loan-to-value ratio isn’t too high. Choosing the right car in the first place is especially important.
Tip #1. Pick a car that is within your budget.
It’s important for so many reasons to pick a car that is within your budget in the first place. This means that you will have the money to not only make a down payment, but you will not have trouble consistently making your monthly payments.
In general, it is a good idea to ensure that you pay no more than 15% of your monthly take home pay on your car payment. Your transportation expenses should not total more than 20% of your total pay. This means gas, parking, insurance, tolls, maintenance, and your car payment should be less than 20%.
Tip #2. Pick a car that doesn’t have a high depreciation rate.
Certain cars depreciate at a faster rate than others, even if all else remains the same. Two cars that are the same age and have the same mileage and wear and tear will still have different depreciation rates. Depreciation is based on what something is worth as it ages, and certain cars are more desirable as used cars than others when they are used. Luxury cars tend to top the list with the highest depreciation rates. The top 10 cars with the highest depreciation rates in 2022 according to iSeeCars are:
- BMW 7 Series: Depreciation rate of 56.9%
- Maserati Ghibli: Depreciation rate of 56.3%
- Jaguar XF: Depreciation rate of 54%
- Infiniti QX80: Depreciation rate of 52.6%
- Cadillac Escalade ESV: Depreciation rate of 52.3%
- Mercedes-Benz S-Class: Depreciation rate of 51.9%
- Lincoln Navigator: Depreciation rate of 51.9%
- Audi A6: Depreciation rate of 51.5%
- Volvo S90: Depreciation rate of 51.4%
- Ford Expedition: Depreciation rate of 50.7%
First time buyers tend to have higher expectations for technology and add ons, and these features are typically not valued as much by used car buyers.
Choosing a car that has a low depreciation rate is a great way to combat a high LTV. Jeeps, Hondas, Toyotas, and Subarus tend to have lower depreciation rates. Even though some of these models may not be as flashy as other cars on the market, they are solid and reliable cars that people will continue to buy used.
Tip #3. Skip the add ons.
A car can very quickly go from being within your budget to being out of your budget relatively quickly. Upgrades and add ons can quickly add thousands to your car’s price tag, and that means thousands more that you will have to finance. Instead of saying yes to every upgrade presented, try to make a list of what is truly important to you. Do you go camping a lot? Then roof racks and all weather mats are probably a good investment. Do you really care about the sound quality and entertainment? Then the better sound system might be a good choice. But chances are there are more than a few upgrades you can pass on completely.
Tip #4. Make a down payment.
This is less of a tip and more of a rule. You should always make a down payment when purchasing a new car. If you do not make a down payment, you will immediately have negative equity. Depreciation begins the second you drive your new car off the lot, meaning your car will lose value immediately while your loan will be for the original total amount. Making a down payment combats depreciation and will help keep your loan from becoming underwater.
Tip #5. Don’t pick a long repayment period.
Long repayment periods mean that your monthly payments will be lower. And this in turn means that it will take longer to pay back your loan. During that time, your LTV ratio can easily increase and become less desirable.
That’s everything you need to know about loan-to-value ratios.
It’s important to understand how loan-to-value ratios work and why they are important. Getting a low LTV ratio in the first place depends largely on selecting the right car and loan in the first place. If you are interested in refinancing your car loan, try to pay down your loan so that your LTV ratio is 100% or less. This will help you to secure the best interest rate and the best terms.
If you are interested in refinancing your car loan, contact Auto Approve today to get your free quote!