All you wanted to know about loan-to-value ratio

Last week, while the Monetary Policy Committee kept the policy rates unchanged, the RBI brought about other significant changes to help borrowers with additional liquidity. One such move was the increase in the permissible loan-to-value (LTV) ratio for loans sanctioned by banks against the pledge of gold ornaments and jewellery for non-agricultural purposes, to 90 per cent. The increase will only be available for loans sanctioned up to March 31, 2021. For gold loans sanctioned on or after April 1, 2021, the erstwhile LTV limit of 75 per cent shall be applicable.

When you try to take a loan from a financial institution, it usually insists on your pledging some asset of value as collateral by way of having skin in the game. The assets that can be pledged include immovable property, gold jewellery and ornaments, shares, or other securities and even your insurance policies.

Adding an extra layer of protection, lending institutions do not generally sanction the entire value of the asset pledged as a loan. This is where the LTV ratio comes into play. The LTV ratio is used to determine the amount of money that can be lent against every ₹100 of assets pledged. Banks can now lend up to 90 per cent of the value of gold ornaments pledged with them, aa against 75 per cent earlier. The remaining value of the asset held by the bank acts as a margin of safety, protecting the lender against volatility in asset price.

The RBI sets the maximum permissible LTV limits for banks and NBFCs for different assets, to curb the risks they take.

For instance, for lower-ticket sized housing loans (that is, outstanding up to ₹30 lakh), the RBI permits banks to lend up to 90 per cent LTV. For loans up to ₹75 lakh, the maximum permissible LTV is 80 per cent, and for loans beyond ₹75 lakh, it is lower at 75 per cent.

For loans against securities, while the RBI has set an overall limit of ₹20 lakh per borrower (₹10 lakh if held in physical form), banks are also required to maintain a margin requirement of 25 per cent of the market value of shares/debentures held in dematerialised form (50 per cent if held in physical form).

For gold loans, banks are now permitted to have an LTV up to 90 per cent (until March 31, 2021). For NBFCs, the limit continues to be at 75 per cent.

While the RBI lays down the maximum LTV, individual banks and NBFCs can set LTVs that are much lower than the overall ceiling mandated. For example, HDFC Bank offers personal loans against property for a maximum LTV of 60 per cent only, irrespective of the amount borrowed. LTV limits can also vary according to the borrower’s risk profile.

The RBI requires financial institutions to maintain LTV limits throughout the tenure of the loan. The ratio should be maintained on the outstanding amount of loan, including interest accrued. Imagine you took a gold loan of ₹10 lakh at 90 per cent LTV. At an interest rate of 9.5 per cent, the loan outstanding at the end of the year would be ₹10.95 lakh including the interest. Even if the gold prices remain constant, the interest accrued takes the LTV ratio to about 99 per cent. The situation could worsen if the price of the yellow metal declines.

Since the margin of safety is so low, borrowers will be required to either cough up more money to prepay that part of the loan or pledge more collateral. In the absence of any of these, the bank may have to treat this as a default. The borrower’s inability to repay could also force the bank to sell the gold pledged as collateral.

Therefore, if you are a borrower, be cautious about jumping in by cashing out all your gold at such high LTVs.

You may want to make hay while the sun shines, but over-exposure can lead to sunburn.

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