If you're in the market for a loan, whether it's a mortgage to purchase a home, a car loan or any other type of personal loan, your loan-to-net-worth ratio is something potential creditors may look at. The loan-to-net-worth ratio calculation may vary slightly depending on the creditor, but it essentially offers some insight into your ability to repay the loan. When applying for a loan, a smaller ratio is typically viewed more favorably by banks and other lenders.
What Is Your Net Worth
Figuring out your net worth may be the most time-consuming part of calculating the ratio as it requires a thorough review of your personal finances. Your net worth is what you have when you subtract your debts from your assets. Assets to consider include the cash you have in all of your bank accounts, the value of your home and other real estate you own, investments, and personal property such as boats, cars, collectibles, jewelry and anything else you own. The debts you subtract from total assets cover your unpaid credit card balances, back taxes, outstanding mortgage, car loans, student loans, other personal loans, plus any unpaid bills you have.
To calculate your loan-to-net-worth ratio, divide the amount you want to borrow by your net worth. To illustrate, suppose you want to borrow $10,000 to make some home improvements. If your net worth is $100,000 at the time of submitting the loan application, your loan-to-net-worth ratio is 1-to-10, or 10 percent. In other words, the prospective loan amount is equal to 10 percent of your net worth. Some lenders, however, reverse the order and calculate it as your net-worth-to-loan ratio, in which case, a larger ratio is more desirable to creditors.
Why Loan-to-Net-Worth Ratio Matters
A primary concern of most lenders is the risk of people defaulting on their loan payments. This is why banks and other financial institutions evaluate each loan applicant's credit history and loan-to-net-worth ratio. If you have too much debt, or more debt than assets, you pose a higher risk than if your assets greatly outweigh your debt. To mitigate this risk, most lenders may require payment of a higher interest rate or won't approve the loan at all. In the event your financial situation changes for the worse, lenders want some assurance that you have the option of liquidating some assets to continue making scheduled loan payments. Therefore, a prospective creditor will likely prefer a loan-to-net-worth ratio of 10 percent over 80 percent.
Similar Debt-to-Income Ratio
Some lenders may use a debt-to-income ratio instead of, or in addition to, the loan-to-net-worth ratio. The debt-to-income ratio compares your recurring monthly debt payments to your monthly income. For example, if your total monthly debt payments -- including mortgages -- is $2,000, and you earn $5,000 of income each month, your debt-to-income ratio is 2-to-5, or 40 percent. This tells lenders that you currently use 40 cents of every dollar you earn to pay off debts. A smaller ratio is preferred by lenders. The actual requirement for a loan approval depends on the lender since the ratio may be acceptable for one but not for another.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.