Loan-To-Value Ratio: Car Loan Terminology Explained

Loan-to-value ratio explains the relationship between the amount you borrow and the value of the car the loan uses for collateral.

Lance Cothern | 

Jun 17, 2022 | 5 min read

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When shopping for a car, you may decide to finance the purchase using a car loan. Lenders look at several factors before approving or denying your car loan application. Two common factors that may influence the decision include the loan-to-value ratio car loan requirements and your debt-to-income ratio as an individual.

To help you understand the process before applying for a loan, here are some key details about these ratios.

How Loan-to-Value Ratios Work

The loan-to-value ratio explains the relationship between the amount of money you borrow for a car loan and the car's value. You calculate it by dividing the loan amount by the car's value (which may differ from the sale price) and multiplying the result by 100 to get a percentage. For example: if you take out a $25,000 car loan to buy a $30,000 car, your loan-to-value ratio would be 83%.

Lenders and Limits

Lenders look at the loan-to-value ratio at the time of the car purchase as a benchmark to make sure they aren't taking on unnecessary risk. This ratio concerns lenders because the car acts as collateral if you default on the auto loan. The lender can repossess the car to get some of their money back. However, loan-to-value ratios over 100% result in the lender not getting fully reimbursed when they sell the car. For this reason, lenders may limit the maximum loan-to-value ratio for their car loan approvals.

Your loan-to-value ratio may exceed 100% when you trade in a car where you owe more than the value you'll receive for your trade-in vehicle. Some lenders may allow the loan-to-value ratio to exceed 100%, but each lender may have a limit. Particular lenders may allow a higher loan-to-value ratio for refinanced car loans than car purchase loans. It's a good idea to ask potential lenders what their limit is before applying for a loan.

Ideally, you want to keep your loan-to-value ratio below 100% so you don't owe more than your car is worth. A lower loan-to-value ratio when you take out a loan could result in more favorable loan terms in some cases. The easiest way to lower this ratio when taking out a car loan is to put down a larger down payment on the vehicle. The down payment reduces the loan amount while the car's value remains the same. This lowers the ratio calculation.

How Loan-to-Value Ratios Change as They Age

As you pay off your loan over time, the loan-to-value ratio will change. Part of the change happens because you pay off part of the loan, lowering the loan portion of the calculation. The car's value changes over time as the vehicle depreciates based on age, mileage, and condition. A car normally depreciates quicker early in its life, which means the loan-to-value ratio may increase during the early stages of your loan term. As the loan ages and you make payments, the loan-to-value ratio generally declines at a more predictable pace.

How Debt-to-Income Ratios Work

The debt-to-income ratio is another car loan qualification metric lenders review. You can calculate this ratio by adding up the total amount of all monthly debt payments and dividing it by your monthly income. Then, you can multiply that number by 100 to get a percentage. For example: if your total monthly debt payments equal $1,200 and your monthly income adds up to $3,000, your debt-to-income ratio is 40%. Specifically, your lender considers your debt-to-income ratio after including your proposed car loan payment.

The lower your debt-to-income ratio for a car loan is, the more comfortable a lender may feel when lending you money for a car purchase. A lower ratio essentially means you have more of your income available to make debt payments, including a new proposed car loan payment. Ideally, you'd like to keep your debt-to-income ratio as low as possible, but some lenders may accept ratios as high as 45% or 50%.

Improving Your Debt-to-Income Ratio

You can improve your debt-to-income ratio in two ways:

1. First, you can lower your monthly debt payments. You can work to pay off particular debts that have payments that change based on the amount you owe, such as credit cards. However, paying off part of your mortgage wouldn't help because your monthly payment would remain the same.
2. The other option to lower your debt-to-income ratio requires increasing your income while keeping your monthly debt payments the same. The percentage declines since you divide the same debt payments by a larger income number.

Lenders also use your credit score as part of the application process. If you're trying to improve your credit score to get approved for a car loan, you may have heard that you need to lower your debt-to-income ratio. Contrary to popular opinion, your debt-to-income ratio doesn't impact your credit score. Your credit score is calculated based on information in your credit report, and your income is not listed anywhere on your credit report.

However, lowering the debt you owe could potentially help your credit score. The amount of credit you use compared with your available credit falls into one of the more significant credit scoring factors, called credit utilization. By paying off debt, you can lower this ratio, which may help to improve your credit score depending on the credit scoring model used and your particular situation.

Verify Before You Apply for a Smoother Application Process

The debt-to-income and loan-to-value ratio car loan requirements may be flexible or set in stone depending on the lender. Before applying for a loan, make sure you understand the specific lender's requirements regarding debt-to-income and loan-to-value ratio amongst others. Do be aware not every lender may disclose their ratios.

Lance Cothern

I started reading everything I could about personal finance while I attended college. It turns out that was one of the smartest decisions I could have made. Now, I want to share that knowledge with you. Using what I've learned through my education and experience, I aim to help you make informed decisions throughout the car buying and lending process while saving money at the same time.