Why do lenders use the loan-to-value ratio in underwriting?

Lenders use the loan-to-value ratio as a critical factor in underwriting to assess the risk associated with a loan application. The loan-to-value ratio is calculated by dividing the amount of the loan by the appraised value of the property. A fundamental reason for this practice is to ensure that the loan amount does not exceed the fair market value of the property, providing a safeguard for the lender against potential losses in the event of borrower default.

By maintaining a loan amount that is less than the property's value, lenders can mitigate risk and ensure that the borrower's equity in the property provides a cushion against fluctuations in the real estate market. This is particularly important since if the borrower defaults, the lender may need to repossess the property, and having a loan amount that is lower than the property value increases the likelihood of recovering the loan amount through a sale.

Understanding this metric helps lenders make informed decisions about how much to lend, imposing conditions that will protect their investment while also ensuring that borrowers are not in over their heads financially. This aligns with the lender's objective of minimizing the risk involved in granting loans.