What is the purpose of a loan-to-value ratio in mortgage lending?

The purpose of a loan-to-value ratio (LTV) in mortgage lending is to determine loan risk. LTV is calculated by taking the amount of the loan and dividing it by the appraised value of the property. A higher LTV indicates that a larger portion of the property is financed through a loan, which can be seen as riskier for lenders. This is because if a borrower defaults, the lender may have difficulty recovering their funds from the sale of the property, should the property be worth less than the outstanding loan amount.

Understanding the LTV helps lenders make informed decisions about how to structure loans, what interest rates to offer, and whether to require private mortgage insurance (PMI). Borrowers with lower LTV ratios are often viewed more favorably, as they have more equity in the property, which mitigates risk for the lender.

The other options focus on different aspects of the lending process. Assessing creditworthiness involves reviewing a borrower's credit history and score, which reflects their ability to repay debts. Evaluating payment history looks at how consistently a borrower has made their past payments, also related to credit risk. Estimating property value pertains to determining the fair market value of the property, which is important for the appraisal process but