If you've ever taken out a loan, you might wonder exactly what standard it is that banks and other lenders use to determine whether the collateral that you offer is good enough to secure the loan that you request and how much interest they're going to charge you for that loan.

One of the major factors that is used in making this determination is the loan-to-value ratio, which helps to tell a potential lender exactly how much of a risk they might be taking in issuing a particular loan based upon the collateral that is being used.

The loan-to-value ratio can be a major factor in loan approval decisions, but in the end it's simply a comparison of how much certain collateral is worth compared to how much an individual wants to borrow.

The information provided below should shed a little more light on this important but often overlooked consideration.

Looking at the Ratio

In order to best understand how a loan-to-value ratio works, you should take a moment and consider exactly what the name of it implies. If the loan that you're requesting is for more than the value of the collateral (hence, loan-to-value), the likelihood of the loan being approved isn't very good especially if you have less-than-perfect credit. The loan amount divided by the collateral value (to get the ratio) ends up being a number larger than 1… that's bad. If you take the other option in this scenario and request a loan for an amount that is much less than the value of the collateral, then the ratio ends up being a number that's less than 1. The smaller this number is, the better.

In order to determine the percentages involved in this ratio, simply multiply your result by 100. If the result is over 1, then the requested amount is over 100% of the collateral's value. You want to be well under 100%, since if the lender has to take possession of the collateral and put it up for sale they'll have additional expenses that also need to be covered by the value of the collateral.

Determining Collateral Value

While you might be able to have your collateral appraised in order to determine the value, lenders are likely to use their own appraisers or the standard market value of similar items if the standard market value can be determined. This includes the “blue book” value of vehicles, as well as the going rate in standardized value guides for most collectables.

To make matters worse, lenders also look at the availability of a market for the collateral item… the harder it would be for them to find a buyer for the item in question, the lower the loan-to-value ratio needs to be. You should keep this in mind when determining your collateral for your loan and attempting to find a standard value for it.

Optimizing Your Loan-to-Value Ratio

In order to get the most out of your loan-to-value ratio, it's important to try to use a high-value item with an easily-accessible market as your collateral. Vehicles, real estate, and home equity are common forms of collateral in large part due to their relatively high value and the ease of working with them should the lender need to take possession.

If you can't seem to get the collateral value where it needs to be, you can also reduce the amount that you're asking for in the loan… this will also help to bring down the ratio and make you much more likely to be approved.

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