Understanding the Loan-to-Value Ratio
The loan-to-value (LTV) ratio is a financial term lenders use to express the ratio of a property's total mortgage financing and the property's appraised value or selling price, whichever is less.
The LTV Concept
Since the risk of default is always at the forefront of lending decisions, the lender uses the loan-to-value ratio to help measure that risk. In this case, the higher the ratio, the higher the lender's financial risk. Why? Because it means that it has a greater equity position in the property, and conversely, the borrower has less of an equity position. And this is bothersome to lenders because it means that the borrower can more easily default on the loan should he or she encounter any financial problems.
Okay, let's start with the formulation and then run through an example situation to make it clearer.
= Loan-to-Value Ratio
Say you want to purchase a five-unit apartment building for $900,000 and approach a lender with a request to borrow $720,000. The property later appraises for the selling price and therefore establishes the property value at $900,000, and you want to know whether the property will qualify for the mortgage you're requesting.
RESULT: $720,000 ÷ $900,000 = 80%
Fairly straightforward. So what does an 80% LTV signify, and more importantly, is it a number the lender will approve?
Simply put, the result signifies that the bank has an 80% equity position in your apartment property, and you have 20%. Whether it would be acceptable to the underwriters depends on the policies of the lender, but it's not uncommon for lenders to accept an LTV no higher than 70% (i.e., they want you to assume 30% of the risk).
In other words, it's unlikely you can get your desired mortgage, and probably might only qualify for $630,000. Of course, this is not good for you because it means that either you go back to the seller and renegoiate the price down, you put more cash down in order to close the deal, or you drop the deal entirely.
Rule of Thumb
The real estate investor typically prefers to buy a rental property with as little cash down as possible. This is known as "leverage" because the investor is able to use more of the banks money to make the investment and thus leverage his or her investment.
In some cases, like with our example, the investor might not have a choice and might have to forsake leverage in order to make the acquisition. It all depends on how badly the investor wants the property.
So You Know
ProAPOD's two real estate investing software solutions—Agent 6 and Executive 10—as well as its Pro RE Calculator real estate calculator program compute the loan-to-value ratio.