If you’ve been ‘round us here at Awesomely for a hot minute, you’ve probably come across many real estate formulas that can help you succeed: cap rate, loan to value ratio, debt to equity ratio , PITI, gross rent multiplier, the MAO formula and more.
In this article, I want to talk about one of these specifically: loan to value ratio and how it can help your real estate business today and in the future.
Now, when it comes to your money — let’s face it — we need/want to know where it’s coming and going. Enter LTV: The place where a project begins… but could also end before it starts.
LTV = loan-to-value
It’s a ratio metric that compares the amount of a loan to the value of an asset — like, you guessed it, a property. And it’s really all about risk…
Lenders use the LTV Ratio to assess the risk it’ll face if it lends money and also to determine the terms of the loan or line of credit. The risk being whether the property goes into default and the funds can’t be repaid. Yikes.
Now, when there’s a higher LTV Ratio, that means the borrower is taking on more risk, and that in turn, could lead to higher interest rates or a complete denial of the loan request. A lower LTV, which means less risk, can increase the chances of loan approval and even better interest rates.
It’s not just for lenders, though… you’ll use the LTV to help you decide if a property is worth it for you as an investor.
So, read on to see the easy-to-follow loan-to-value ration calculation, and how it can help investors make smart decisions.
What Is a Loan-to-Value Ratio (LTV) in REI?
Very simply, the LTV ratio compares:
- the amount of money you borrow
or - the amount of debt you’d take on when buying a property at the appraised value
or - the fair market value of an investment property.
The result is expressed as a percentage. (Formula below!)
Like I said, investors and lenders use the LTV as a tool for helping determine if an investment can be successful or if it’s too risky.
Understanding the LTV Ratio
LTV can be used for several things: a mortgage… refinancing… home equity loan… and a line of credit.
A big factor in this calculation involves the amount of down payment or deposit, sales price, and the appraised value. You should know all those figures before embarking on a deal.
See, after the deposit amount is figured out, the remainder of the deal would still have to be paid through some type of loan. That’s the L in LTV.
Of course, the V is the value of the property… usually appraised value or fair market value.
Fun fact: The value can also include what the property is going to be used for — rental or perhaps business — which can be a source of income.
Why Is the LTV Ratio Important?
You’re making the decision to invest or move on, right?
Well, the LTV lets you know what you’re getting yourself into, because whatever you borrow, as we all know, you have to pay back… with interest.
And unfortunately, you’re not the only one who gets to make that decision… lenders use this ratio all day every day for REI.
How Lenders Use the LTV Ratio
So, the LTV is part of lenders’ deciding factor on whether or not they should provide a loan for a particular investment or if they want the investor to bring in more money for a down payment or deposit.
Because risk, remember?
Lenders’ assessment of the property and risk level for the investment is key to what they decide they’d be willing to lend out.
For example, if a property’s value is $400,000 and lenders give you a loan for 75% of it. They use the Loan-To-Value Ratio to figure out how much money to give you — here, that’s $300,000. (Formula coming, hang tight…)
See, if you’re taking a loan out to make the purchase, the money folks want you to have something in the game too. Private lenders, just like banks, don’t want all the risk just to let you reap all the rewards.
Nope, investors have to step up to the plate, too, and get in the game by providing a down payment.
Let’s look at another example…
When a bank assesses a property, it then provides a fair market value. If the property is assessed at $1,000,000, and you want to secure a loan for $500,000, the LTV ratio would be 50%. Of course, in this example, you would be providing a down payment of $500,000, or maybe you’re working with a group of investors to reach that number.
How to Calculate the LTV Ratio & Is There a “Good” LTV?
As promised, the formula!
All it takes is simple math. Yep, I mean it!
Just take the amount of the loan or the money you’re borrowing and divide it by the fair market value. The result = LTV; reflected as a percentage.
Source: Wall Street Prep
The fair market value can include variables — location, type of REI, construction/repairs, comps, etc.
So, yes, there is a “good” LTV percentage, but that number is not stationary… private lenders often generally say that number is typically 80%, but 60%-80% is a “good” range.
How do we know what’s “good” for each project?
Lenders typically have a specific percentage they allow as a loan amount for a specific project, which varies, of course, based on each deal and the risk assessment. In fact, they can decide on an LTV percentage before they even get the appraisal!
How’s that?
Well, if a project comes back appraised at $4,000,000 and the lenders had agreed to a loan for 25% of the appraised value, the loan amount would be $1,000,000, and the rest would be a deposit.
Final Thoughts — What Is a Loan-to-Value Ratio (LTV) for REI?
As we wrap up, know this: If the proposed loan amount exceeds the value of the property, it’s best to find another investment.
Why?
Because it’s not only high risk, but you’re not gonna get the loan. (At least not from whichever lender you were working with — bank, private, or otherwise.)
In other words… it’s not worth your time or money or risk, and it’s not worth the lenders’ either.
Just like when you were in school, the higher percentages for a Loan-To-Value Ratio are what we are all looking for, giving us less immediate risk. But unlike school, it’s the opposite of what the lenders will let you pass with… they do want their money back, of course.
Consider your deposit, then what you want/need the loan to be, compare it to the value, and see if it’ll make the investment worth it for everyone.
And of course, look at other options if needed… bring in other investors to partner with. Perhaps they bring more of a down payment to the table… that could lower the LTV ratio in your favor.
Remember: Don’t let the LTV be your only deciding factor. Use the Loan-to-Value Ratio alongside other tools — like the Cap Rate, which we’ve discussed in a previous Awesomely blog post.
Now, grab your next REI deal with help from the Loan-to-Value Ratio.
