Loan-to-Value (LTV): The Significance and Formula
by James Kobzeff
Loan-to-value (LTV) is a measure related to mortgages that lenders use as a measurement of financial risk. Namely, because it determines the amount of funds a bank is willing to loan (how much financial risk it's willing to take) to finance an investment.
All of which, of course, is important to the real estate investor because it decides the amount of funds that can be borrowed against the investment (amount of leverage), the cash down payment required, and in turn the amount of financial risk to the investor.
How to Calculate
Loan-to-value is the ratio of the debt to the actual value (commonly the lesser of the appraised value or actual selling price) of a property and is calculated simply by dividing the loan amount by the property value.
Loan-to-Value = Loan Amount / Property Value
Example. Let's assume you want to purchase a condo rental income property for $300,000 and 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 of 70%.
How to Interpret
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, now consider which loan-to-value in the examples given above. Which benefits the real estate investor with the best leverage between use of borrowed funds to finance and actual investment?
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.
So You Know
All ProAPOD® Real Estate Investment Software solutions compute loan-to-value automatically as you enter the property data. It is recalculated in real time each time you make changes so the correct computation is always posted to the appropriate reports.
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