Definition: Loan-to-value (LTV)
The Loan-to-Value (LTV) ratio is a financial metric used to measure the ratio of a loan compared to the value of the asset being purchased. It serves as a critical tool for lenders to assess the risk associated with a loan. The loan-to-value (LTV) ratio is calculated by dividing the loan amount by the appraised value or purchase price of the asset and then multiplying by 100 to get a percentage.
What's the purpose of loan-to-value (LTV)
Loan-to-value or LTV is significant for several reasons. First, it helps lenders assess risk. A higher loan-to-value (LTV) ratio indicates that the borrower has less equity in the asset, making the loan riskier for the lender. This is because in the event of default, the lender might have difficulty recovering the full loan amount through foreclosure or asset liquidation.
Lenders thus often have maximum loan-to-value (LTV) thresholds; for instance, most mortgage loans in Switzerland never go beyond a loan-to-value ratio of 80%. Additionally, loans with higher loan-to-value (LTV) ratios typically come with higher interest rates to compensate for the increased risk, while lower loan-to-value ratios may qualify borrowers for better interest rates.
LTV and collateral value
Collateral value refers to the estimated fair market value of an asset that a borrower pledges as security for a loan. This value is determined through an appraisal or valuation process and represents the amount a lender could expect to recover if the borrower defaults on the loan and the asset needs to be sold. The collateral value is a critical factor in determining the loan-to-value (LTV) ratio, which in turn influences the loan's risk assessment, approval process, terms, and interest rates.
Loan-to-value (LTV) and collateral value: formula
LTV = (Loan Amount / Collateral Value) ×100
Loan-to-value (LTV) and the "lower of cost or market" principle
The lower of cost or market principle requires that an asset be valued at the lower of its historical cost or its current market value. When determining the collateral value for calculating the loan-to-value (LTV) ratio, lenders aim to mitigate risk by ensuring that the loan amount is a conservative percentage of the asset's value. This approach protects lenders from potential losses if the borrower defaults and the asset must be sold or a home foreclosed. In Switzerland, all mortgage loans are subject to the lower of cost or market principle.
Loan-to-value (LTV) of mortgage loans in Switzerland
In Switzerland, the loan-to-value (LTV) ratio for mortgages is governed by regulations that mandate banks to mortgage a property up to a maximum of 80% of its value. The "lower of cost or market" principle applies in determining the collateral value, which means the collateral value used for the mortgage calculation is the lower of the purchase price or the fair market value.
For instance, if a house is valued at CHF 1,000,000 and a buyer purchases it for the same amount, the buyer's bank will typically grant a mortgage of CHF 800,000, adhering to the 80% loan-to-value (LTV) ratio. This in turn means that for a home worth 1 million CHF, a buyer has to have at least CHF 200,000 in equity. This straightforward scenario assumes that the purchase price and the appraised value are identical.
However, if the bank appraises the property at a lower value, say CHF 800,000, even though the buyer paid CHF 1,000,000 for it, the lower of the two values has to be used as the collateral value. According to the lower of cost or market principle, the buyer would then be eligible for a mortgage of 80% of CHF 800,000, which is CHF 640,000. Consequently, the buyer would need to cover the difference between the purchase price and the appraised value with a higher down payment. This scenario is somewhat common in high-demand regions such as the city centres of Zurich or Geneva, where purchase prices are high and there are a lot of buyers bidding on the same property.
This approach ensures that banks in Switzerland mitigate their risk by not overextending credit based on potentially inflated purchase prices. This ultimately protects both banks and homeowners, though it limits who can afford to buy property in Switzerland.
Are there exceptions to loan-to-value (LTV) limits in Switzerland?
While the loan-to-value (LTV) criteria are set by law, financial institutions do have some room for leeway. This applies in particular to exceptionally creditworthy borrowers, such as those with very high income or a lot of assets. In these cases, banks may occasionally exceed the default loan-to-value (LTV) ratio of 80%.
Another instance where the loan-to-value (LTV) ratio may be exceeded is in interim financing when changing homes. In this case, the mortgage on the current property may be temporarily increased to free capital for purchasing a new home. Many financial institutions allow the loan-to-value ratio to exceed the usual 80% limit during this interim period. However, as this is a temporary solution, the borrower will again need to meet the usual loan-to-value requirements once the old property has been sold.
Why are loan-to-value (LTV) requirements as they are in Switzerland?
The stringent loan-to-value (LTV) requirements in Switzerland are a direct response to past financial crises, aimed at ensuring the stability and resilience of the financial system and by extension, the rest of the economy. Notably, the 2007/2008 global financial crisis and the Swiss recession of the early 1990s serve as cautionary tales that underscore the need for conservative mortgaging practices. Both of these events lead to multi-year recessions, waves of foreclosures, and banks failing. And, crucially, both the 2007/2008 global financial crisis as well as the Swiss recession of the early 1990s had their origin in bursting real esate bubbles, which in turn were made possible by lax mortgaging standards and overvalued properties.
These events had a profound impact on Swiss financial regulation. The stringent loan-to-value (LTV) requirements, typically limiting mortgages to 80% of the property value, are designed to prevent a repeat of such crises. By ensuring borrowers have substantial equity in their properties, these regulations reduce the risk of defaults and ultimately protect the financial system. The conservative loan-to-value (LTV) thresholds help maintain market stability, ensuring that both lenders and borrowers are better insulated from potential downturns in the real estate market.
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