The Loan-to-Value Ratio
Loan-to-value ratio (or LTV) is a financial term associated with mortgages that lenders use to help them determine the amount of funds they are willing to loan (financially risk) to finance a real estate investment.
Loan-to-value ratio is fairly straightforward: It is the ratio between the mortgage amount and the property's appraised value or selling price (whichever is less). For instance, if the property's selling price is less than the appraised value the lender will base the LTV on the selling price, otherwise the lender will make the computation based upon the appraised value (if less).
The result, of course, is important to the real estate investor because it decides the amount of funds that can be borrowed against the real estate investment and consequently the amount of the cash down payment required. Typically referred to as "leverage", less cash down payment signifies higher leverage and more initial cash investment lesser leverage.
Loan-to-Value Ratio = Loan Amount / Lessor of Property's Appraised Value or Selling Price
Let's assume you want to purchase a condo rental income property for $300,000 (also the appraised value) and therefore can borrow $210,000. You would divide the loan amount of $210,000 by property value of $300,000 to determine a loan-to-value ratio of 70%.
What it Means
EXAMPLE ONE. Suppose the lender informs you that they require a 70% loan-to-value. What are they telling you? That they will accept 70% of the financial risk (or $210,00 worth of risk) and in turn require you to accept the other 30% (or $90,000 worth of risk).
EXAMPLE TWO. The bank reconsiders and decides it wants a 60% loan-to-value. What does that mean? That the bank has decided to take less of a financial risk (just $180,000) and wants you to take more of the risk ($120,000).
Okay, from the two examples illustrated above, which loan-to-value ratio benefits the real estate investor with the better leverage?
The correct answer, of course, is that a 70% loan-to-value gives the investor the better leverage. Why? Because it means he or she can purchase the investment with more of the banks money, less cash of its own, and in turn can shift more of the financial risk onto the lender.
Does that mean the real estate investor has a choice? Probably not. Remember that lenders use LTV to measure their own financial risk so in most cases the investor will have to accept what the bank offers.
So You Know
ProAPOD's two real estate investing software solutions as well as its online real estate calculator compute the loan-to-value ratio.