What is the purpose of the loan-to-value (LTV) ratio?

The loan-to-value (LTV) ratio serves primarily to assess the risk of the loan. It is a financial term that compares the amount of a loan to the appraised value of the property being financed. A higher LTV ratio indicates a greater risk to the lender because it implies that the borrower has less equity in the property. If a borrower defaults on the loan, a higher LTV means the lender may not fully recoup their investment upon selling the property since there is a smaller buffer of equity.

LTV is closely monitored by lenders when underwriting loans, as it helps them gauge the likelihood of default. If the LTV is high, lenders may require additional safeguards, such as private mortgage insurance (PMI), to mitigate their risk. This calculation is crucial because it directly impacts lending decisions and interest rates, but its primary function is risk assessment.