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LTV Ratio: The Magic Number in Car Finance

LTV Ratio: The Magic Number in Car Finance

30 November 2020 Concept Car

Would you like to know a magic number? A number that can keep you out of trouble when applying for car finance? Which can improve your chances of getting accepted for a loan, while keeping the costs down?

Then you really need to read this article.

The LTV ratio is one of the best approaches we know to make your car loan a success. And best of all, it’s strikingly simple.
Ready to save money and reduce your monetary risks? Let’s begin.

LTV Ratio: Definition

What is the LTV ratio? Simply put, it is the ratio between how much you’re borrowing and how much your car is worth.

The higher the ratio, the more you are borrowing.

To calculate the LTV, you divide the total cost of the loan in Pound by the actual current cash value of the car in Pound.

As an example, let’s say you want to buy a £7,500 used Ford Fiesta. You borrow £5,000 and cover the remainder with savings from your bank account.

In this case, the LTV is 0,67.

What does the LTV signify?

Okay, now you know the LTV in our example is 0,67. What does that mean, exactly?

If the LTV is less than 1, this means that the car is worth more than what you borrowed. So if you can no longer keep up the repayments, the dealer can sell the car and recoup her expenses.

If the LTV is higher than 1, the dealer will make a loss if selling the car. This is because she lent more to you than what the car is worth. Do note, however, that the LTV is a dynamic number. The value of the car is constantly changing – just think of the massive depreciation in the first two years – and so is the amount you repayed.

Being upside down on a loan

If your current car credit is worth more than the vehicle itself, we refer to this as “being upside down on the loan”. The idea behind this phrase is that things are exactly the other way around from what you’d expect: You shouldn’t have to borrow more than what the car costs, after all.  Usually, you would borrow either exactly the amount you need (LTV=1) or slightly less (LTV<1).

So how do you get into this dilemma?

Let’s think about how you can get upside down on a loan.

There are two situations which commonly lead to this situation.

Firstly, if you buy a new car, depreciation is very high in the first year. If you’re paying the loan off slowly and with low monthly instalments, this loss in value will initially outpace your repayments. As a result, typically before you hit the 1 or 2-year mark, many drivers in the UK find themselves upside down on their loan.

The second situation occurs if you’re rolling over a loan from your previous car. Let’s return to our imaginary Fiesta and imagine you still have £3,000 in debt from your previous car. If you roll over this loan into the next one, you now need to borrow £8,000 to afford the deal. But the car is only worth £7,500.

Now, your LTV is 1,07 and you’re upside down.

Have you read:
Getting a Used Ford Fiesta – What you should know
Refinance or Roll Over a Car Loan?

Being upside down does not have to be a problem per se.

Especially if you’re buying new, all you need to do is soldier through the first few years. Depreciation eventually slows down, while your repayments keep adding up.

And rolling over a loan can, in select cases, be helpful in getting into the black again. Explains financial expert Melissa Blevins:

“Most of the time, when purchasing a vehicle, you’d want to calculate the loan to value to ensure your lender will cover any negative equity you may be rolling into the car loan. The only time I recommend doing something like this is if you are paying outrageous payments on a vehicle you purchased new and are upside down but wanting to trade down your vehicle to get out of debt quick. I’ve done this, personally, when my husband and I traded in our minivan for a vehicle that was 1/4 of the cost of the van. It was well worth it, but you have to know when you do this, the car you trade into is going to be your car for many years (or at least until you can save up cash to pay for a replacement).”

But there are significant downsides to being upside down.

An LTV ratio higher than one usually spells trouble.

On your end, the higher the LTV, the more you’re relying on someone else’s cash to pay for your car. This means that the risk of running into financial trouble at some point increases.

This has a plethora of downsides to it:

  • The higher the risk of a default, the higher your chances of getting rejected for a credit.
  • The higher the risk of a default, the higher the interest on the loan. Thus, your loan will become more expensive.
  • Lenders may also dictate more severe terms and conditions in case your LTV rises to dangerous levels. If you want to refinance the loan at some point, a high LTV may make this more difficult and/or expensive.

So, as you can see, a high LTV ratio offers plenty of potential for problems.

What is a healthy LTV ratio?

We all have different needs and we all have different financial pasts. So what is ideal for someone else may not be ideal – or feasible – for you.

In some cases, a high LTV ratio may be okay. As long as you can pay off the loan, the mere fact that this particular number is bad doesn’t mean anything, really. In other cases, you may simply need a vehicle and may have to accept a higher LTV, despite the disadvantages.
Just where the border between good and bad runs is, therefore, hard to say.

Experian writes:

“If you’re taking out a conventional loan to buy a home, an LTV ratio of 80% or less is ideal. Conventional mortgages with LTV ratios greater than 80% typically require PMI, which can add tens of thousands of dollars to your payments over the life of a mortgage loan. (…) LTV ratio is a less crucial factor with auto loans. While you might pay higher interest on a car loan with a higher LTV ratio, there’s no threshold comparable to the 80% LTV that earns the best mortgage loan terms.”

We disagree with this.

There is an ideal LTV ratio.

Across the board, experts recognise a clear LTV maximum. According to most of them, you should never, under any circumstances, accept an LTV higher than 125-130%.

This sound like sound advice. Although you will sometimes have to go upside down on your loan, the lower you keep your risk, the better.
If there is a recognised maximum, why shouldn’t there be an ideal LTV as well?

From our experience, just recommending ‘the lower, the better’ isn’t very helpful.

Instead, somewhere between the 50-80% mark is your safe zone. Within this space, your risk of a default is kept low. At the same time, you protect your reserves in case something should go wrong.

How to reach the LTV safety zone

Reaching this safety zone may not be possible for you at this point. That, however, doesn’t mean you can’t try to come close.
Here are the most obvious ways to reduce the LTV:

  • Buy a cheaper car.
  • Use up more of your savings to buy the car. This will keep the loan costs down.
  • Take up a second loan from friends and family.
  • Put down a (larger) downpayment.

Of these, a cheaper car and a larger downpayment are your best options. They are great solutions, because they also reduce your costs. Taking up a second loan from friends and family may be more helpful for your LTV. But it can cause personal tensions and lead to issues down the line.

Additionally, you can also:

increase your monthly instalments as soon as your financial situation allows this. Whether or not this is possible will depend on your contract.make the occasional additional payment. This, too, won’t always be possible.

Have you read:
How do I get the cheapest car loans?

High LTV ratio: What about GAP insurance?

You’re probably familiar with the Gap insurance mis-selling scandal from a few years ago. Back then, dealers sold expensive and entirely unnecessary insurances to unsuspecting car buyers.

Since then, GAP insurance has never fully recovered from its bad reputation.

The basic idea behind this insurance, however, isn’t all bad. GAP insurance is meant to protect you if you need to sell your car and are upside down on your loan.

If your LTV ratio is high, the money you can make by selling it won’t cover the full cost of the loan. So you’re left with debt even after doing away with your car.

GAP insurance was created specifically to deal with this problem. If you need to sell the car at some point and the resale value is not enough to pay back your lender, then GAP insurance will cover the difference (‘gap’).

GAP insurance undeniably serves a purpose. But you need to be aware that it also adds to your monthly expenses and that it won’t cover all situations. We don’t generally recommend it. And even if you do take out an insurance, make sure to read the fine print to know exactly what’s included – and what isn’t.

Have you read:
Car Insurance: What do I really need?

LTV ratio: A magic number?

So, do we really think that the LTV ratio is a magic number?

In some respects we truly do. It is very simple, dynamic and yet very powerful. It is one of the best indicators of how risky a loan is and it can also show you if, by taking action, you are taking the right steps to reduce that risk.

That said, there are obviously many other factors to consider as well. The interest rate and loan term, for example, need to be taken into account as well. If you can pay off the loan quickly, then a high LTV can be okay, for example. And if the interest rate is very high, even a loan with a low LTV may seem unattractive.

If you need help, you can always ask us. Just give us a call or use our easy contact form to enquire about our rates and conditions. We’ll get back to you quickly to help you find and finance the ideal car for you.

30 November 2020 Concept Car