If you’re considering opening up a portfolio line of credit, you need to understand a concept called the loan-to-value ratio (LTV). It’s a technical term that describes the relationship between a loan amount and the value of the asset that’s backing it.
When you’ve taken out a loan that’s secured by investments that are traded on the public markets, your LTV ratio can change quickly. That can sound scary, but sticking to responsible borrowing practices (like not borrowing the maximum amount) can keep your LTV ratio well below the danger zone.
What is LTV and why does it matter
An LTV ratio is a leverage ratio that measures how much you’ve borrowed against an asset compared to that asset’s value, expressed as a percentage. It indicates how exposed a borrower is to defaulting on their loan.
Simply put, the higher the LTV, the greater the risk that the borrower won’t be able to repay the debt, because they don’t have enough equity backing the asset. A lower LTV indicates the borrower has more equity and is less at risk of defaulting.
The simplest way to understand LTV is to think of the mortgage on a home: the percentage the mortgage represents of the property’s total value is its LTV ratio. In the case of a $400,000 mortgage on a $500,000 property, the LTV would be 80%, and the homeowner’s equity is the remaining 20%. It’s why homebuyers have to get mortgage insurance if their down payments are less than 20%: they’re seen as having a much higher risk of not being able to afford their mortgage payments.
Portfolio lines of credit — secured lines of credit you can take out with your financial institution where your investment portfolio acts as the collateral — tend to have lower credit limits, to help ensure major market swings don’t compromise the loan. This also keeps the LTV on the lower side. However, when you borrow against investments, your LTV can change quickly if the market value of the underlying assets jumps or falls.
How to calculate your loan-to-value ratio
Your LTV ratio has a simple formula: divide the loan amount by the value of the asset backing it, then multiply by 100 to get a percentage.
Loan amount: how much you’ve borrowed or want to borrow.
Asset value: the current market value of the collateral, whether that’s a home or an investment portfolio.
For example, if you borrow $30,000 against a portfolio worth $100,000, your LTV is 30% ($30,000 divided by $100,000). If that portfolio later grows to $120,000 and your loan stays the same, your LTV falls to 25%. If it drops to $80,000, your LTV climbs to 37.5%.
The ratio moves whenever either number changes, which is why it’s worth recalculating as markets shift.
Benefits vs. risks
Benefits
Using an asset like your investment portfolio as collateral to borrow can be an effective tool: it gives you increased buying power for investing, major purchases, or life milestones like a wedding, a bucket-list trip, or renovation. It can also be used to cover unexpected expenses.
Risks
Interest rate risk: portfolio lines of credit typically have lower interest rates than unsecured personal lines of credit, and can even have lower rates than home equity lines of credit (HELOCs). But the interest rate is variable, so if the Bank of Canada’s overnight rate increases, it can become more costly to pay down your loan.
Additional fund requirements: if you borrowed near the top of your credit limit and a market downturn causes your portfolio value to drop significantly, your LTV could exceed its allowable limit — prompting your financial institution to demand you add money or eligible securities to your portfolio or pay down your loan, otherwise they may liquidate your securities.
Why market volatility changes the equation
Your LTV isn’t a static figure. If the market value of your assets drops, then your LTV will automatically rise because the loan now represents a larger share of the total.
When you borrow against your investments, there’s always a chance that a market downturn could take a bite out of your portfolio value. If it drops significantly, it could drive your LTV up past what your brokerage allows — meaning you no longer have enough collateral to secure your loan. This is much more likely if you’ve borrowed close to or at your credit limit.
If that happens, your brokerage would issue a demand that you add funds to the investment account securing your line of credit, or sell securities to pay down the loan.
Your brokerage will give you a date to fund your account by. If you don’t meet it, the brokerage can sell some or all of your securities to lower your loan and your LTV.
If you or your brokerage sells securities during a margin call, you might have to sell at a loss. You could also face a tax bill, depending on the account type and any gains.
Calculating a sustainable limit
Before you borrow, give some thought to the worst-case scenario. If the market dropped 20%, what would your LTV be on the amount you’re considering? Conservative investors generally stay below the maximum LTV their brokerage allows, leaving room for market swings that could reduce their portfolio value.
Here are some examples of what both scenarios might look like, if your portfolio value is $100,000 and your brokerage allows you a maximum LTV of 30%.
Let’s say you’ve borrowed $25,000 and the market drops 20%, bringing your portfolio value down to $80,000. Your LTV would quickly jump from 25% to 31.25%. You would need to pay down $1,000 on the loan to lower your LTV to the 30% maximum.
If you had borrowed $10,000 and the market dropped 20%, your LTV would rise from 10% to 12.5%. You would not need to take any action, since that’s well within the 30% LTV maximum.