Over 275 million registered vehicles travel across the United States. It’s no surprise to see many people embrace cars due to the amount of distance they can cover, but getting a vehicle isn’t cheap. The average price of a new car recently exceeded $47,000, and some people need to take out a loan to purchase their vehicle.
Lenders incur risk based on the gap between a vehicle’s actual value and the loan’s principal. Although the vehicle acts as collateral, lenders can be on the hook for losses if the LTV ratio exceeds 100%. Lenders have varying rules, but most will set the max LTV at 125%-130%. Making monthly loan payments will get you closer to a 0% LTV ratio, but your car’s depreciating value can keep your LTV ratio high for multiple years. Cars lose substantial value in their first year and continue on a gradual decline. Understanding LTV and its limits can help you save money on your car loan and get approved for better auto financing.
What is LTV (Loan-to-value) Ratio?
The LTV ratio measures the loan’s principal against the asset’s value. Many car owners use an auto loan to finance their purchases. Therefore, a higher LTV ratio implies the car owner incurred more debt to purchase their vehicle. More debt will lead to a higher interest rate, and some lenders will only work with you if you make a high down payment.
The Importance of LTV Ratio
Lenders consider your LTV ratio before deciding on a loan’s terms and if you’ll get approved. A higher LTV ratio increases a lender’s risk and leads to higher monthly payments. A lower LTV ratio can compensate for a lower credit score and reduce your monthly loan payments. Lowering your LTV ratio also gets you closer to owning your car debt-free.
Your LTV ratio isn’t the only factor that determines your loan’s terms. When reviewing your loan application, financial institutions will also look at your credit score, income, and other resources. Of course, strengthening your finances will help you qualify for better loans, but an excessive LTV ratio can still create a roadblock and increase your monthly costs.
How Your LTV is Calculated
Aspiring vehicle owners must use the loan’s principal and the asset’s value to calculate the loan-to-value ratio. For example, if you make a $10,000 down payment on a new car worth $40,000, you will need a $30,000 loan to cover the difference. You would then divide the loan’s principal by the car’s value. This scenario results in a 75% LTV ratio before driving off with your new ride. However, your car will lose approximately 10% of its value on the first day and up to 20% of its value in the first year. A 10% drop makes the vehicle worth $36,000. You still have an LTV ratio below 100% ($30k / $36k = 83.3%), but the price change provides less cushion than the 75% LTV from earlier.
Most cars lose 20% of their value in the first year, meaning the $40,000 car will be worth $32,000. While this puts you close to the $30,000 principal, you have made 12 monthly payments at this point to lower the loan’s principal. Buying a more affordable vehicle or putting more money down will reduce your LTV ratio from the start, even after driving your vehicle out of the dealership. You can also use a shorter loan term to pay off your vehicle sooner and chip away at your LTV ratio.
Why Lenders Use LTV for Car Loans
The LTV ratio is a valuable metric that helps lenders assess the risk of each loan. Lenders hope borrowers will fully repay their loans, but some borrowers default. A cascade of defaults can put lenders in tight positions, especially if the acquired vehicles have less monetary value than their respective loans. Interest rates help them earn a return on their loans and cushion the impact of defaults. Some lenders incur a higher risk for greater returns by letting borrowers take out loans exceeding 100% LTV.
While the car becomes collateral, this asset isn’t as desirable for a lender. Unlike homes, cars depreciate, and they can rapidly lose value. In addition, a new vehicle becomes less valuable each year as it incurs additional mileage and newer models come out. Lenders don’t want to get stuck on the hook and will employ several mitigation methods. Having the buyer put more money down to reduce the LTV ratio increases the likelihood of an auto loan getting paid in full.
How LTV Affects Your Car Loan’s Interest Rates
Interest rates can significantly impact your monthly loan payments. A single percentage point can increase your monthly payment by over $100. Financial institutions set higher interest rates for borrowers with a greater risk of default. A low credit score and high LTV ratio are riskier for lenders, and many set minimums to mitigate risks.
A high LTV ratio will result in higher interest rates, but each monthly loan payment will lower your LTV ratio. You can secure a lower interest rate by making a higher down payment. Putting more money down reduces how much principal you need to complete the purchase. Building more equity in your vehicle through down payment and monthly loan payments puts you in a better position to refinance your car. A refinance can help you secure a lower interest rate and minimize financial stress. You can use the same concept to refinance a motorcycle or any other vehicle.
Do Down Payments Affect Your LTV?
A down payment increases your equity in the car. Higher equity reduces your loan-to-value ratio and can help you secure more favorable interest rates. All loans reach 0% LTV ratios at their maturity. Lenders want you to hit this LTV number because it means you fully paid off the loan, and they don’t have to repossess a vehicle worth less than the loan’s principal. Making a higher down payment will reduce your monthly payments. For some borrowers, a down payment can make the difference between getting approved or rejected.
Getting a lease for your car will also lower your LTV ratio. This is because car dealers let you buy the leased car for a discount at the end of the lease. Lease payments do not build equity, but purchasing an automobile at a lower price means your down payment will yield more equity. Car drivers with leased vehicles have a few years to save money for a higher down payment. Most lease plans cost less more month than a financing plan, but auto loans eventually get you out of the cycle of monthly payments. You can start with a lease and then use a lease purchase program to buy your vehicle.
What is the Max LTV for a Car Loan?
Consumers should aim for an LTV ratio under 100%, but some borrowers have to take on additional debt. Borrowers can add licensing fees, sales tax, and other expenses to their loan’s principal. Your new vehicle will also lose 10% of its value when you drive away from the dealership. Under these circumstances, your LTV can exceed 100%, but lenders set limits to protect themselves. Most lenders will set a 125%-130% LTV limit so monthly loan payments do not overwhelm their borrowers.
You shouldn’t rush to exceed 100% LTV. An LTV ratio above 100% makes it more difficult to trade in your car in the future. If your car’s trade-in value is $20,000, but you have a $22,000 loan, you will have to pay $2,000 to initiate the trade-in. Some borrowers wait until their LTV ratios fall below 100% before trading in their vehicles. Waiting for the LTV to fall below 100% ensures you get money from your car sale instead of paying additional money for the right to sell your car.
How to Find the Right Lender for You
Borrowers can select from many auto lenders, but not all of them are right for your car financing. In addition, lenders have different credit score requirements, maximum LTV ratios, and other requirements. Doing your research and comparing lenders can help you secure lower interest rates and optimal terms.
