Learn: What Is The Loan-To-Value Ratio In Real Estate Loans

[Hannah Vohs]

When dealing with financing institutions, you’ll find that prior to approving a loan, they carefully vet your investment plan to assess the risk involved with financing it. To do so, there are several industry-standard metrics they review to ascertain whether your loan should be greenlit or not. Some common metrics measured are listed below:

• Credit score: a higher credit score indicates a lower risk for the lender.
• Income: a borrower’s employment history, income stability, and debt-to-income ratio are evaluated to determine their ability to repay a loan. Debt to income ratio is also used to understand whether the income would be sufficient to justify the added debt.
• Collateral: the higher the value of the collateral used by the borrower as security the lower the perceived risk may be.
• Legal Compliance: lenders need to ensure the investment and loan are in compliance with all legal requirements and regulations.

What about the loan-to-value (LTV) ratio?

Another key metric is the loan-to-value (LTV) ratio. The LTV ratio is a measure of how much of the property is financed by the loan. The more the deal is financed by the loan the greater the risk it entails. The formula is quite simple and given below:

Loan amount / Property value = LTV value as a decimal. Multiply the result by 100 to get the percentage value.

As an example, if a property is valued at $10,000 and the loan amount is $9,000 the LTV ratio would be 0.9 or 90%, with the borrower only having 10% equity in the property. On the other hand, if the loan amount is $5,000 the LTV ratio would be 50%. In this case, the borrower has 50% equity in the property. The higher the LTV ratio is, the riskier it is for a lender to provide a loan. Any factors that may reduce the loan amount, such as a larger down payment is also reduced the loan requirement when calculating the LTV. Let's look at a clearer example below:

Say you’re buying a home, which is valued at $150,000, and are able to place a down payment of $50,000. You’ll then require a loan amount of $100,000.

Appraised home value: $150,000

Down payment: $50,000

Value after down payment: $100,000

Loan required: $100,000

LTV calculation = $100,000/150,000 = 0.667 or 67% LTV

In general, most lenders may consider 80% a good LTV ratio and the lower the percentage from here it only becomes more attractive.

Why is the loan-to-value (LTV) ratio important?

While there are several factors that are used to assess how risky a loan application is, the LTV ratio can play a considerable role in determining what interest is offered for the loan. For LTV ratios at 80% or lower, the borrower can expect to receive the lowest possible interest deal. This doesn't mean that an LTV ratio higher than 80% rules out a loan approval, though it does make the approval more difficult.

Additionally, the higher the ratio is, the higher the interest rate offered would be and the borrower may be required to purchase private mortgage insurance (PMI). PMI usually increases the total loan amount by 0.5% – 1% annually, though it is removed when the LTV ratio reaches 80% or lower. The LTV ratio will reduce naturally over time as the loan is paid down and the value of the home increases.

Depending on the type of loan requested, their LTV ratio requirement may be higher or lower and general examples of what it can be are given below in the table:

Loan Type	LTV ratio requirement	PMI required
Federal Housing Admnistration (FHA)	Up to 96.5%	Required through loan period
VA and USDA Loans	LTV ratio up to 100%	Not required.
Fammoe Mae and Fredddie Mac	LTV ratio of 97%	Required till the ratio falls to 80%

Source: Investopedia: Loan-to-Value (LTV) Ratio: What It Is, How To Calculate, Example

Do note however, that the LTV ratio only considers a single mortgage loan when purchasing a property and doesn't take into account any other money borrowed against the property. To make up for this, lenders may use the Combined loan-to-value (CLTV) ratio which provides a thorough appraisal taking into account all outstanding loans on a property to the property's value. Let's look at what this may look like in an example:

Appraised home value: $150,0000

First mortgage remaining balance: $40,000

Second mortgage remaining balance: $60,000

CLTV calculation: ($40,000 + $60,000)/$150,000 x 100 = 66%

Conclusion

The loan-to-value ratio is a key metric used by lenders to evaluate the risk of a real estate loan. It is important to lenders because it determines the amount of equity the borrower has in the property. By understanding how the LTV ratio is calculated, investors can proactively work towards minimizing the ratio amount by ensuring the loan amount is as low as possible, thereby making it easier to have the loan approved as well as securing better interest rates for the loan.