An important item to consider when deciding if a note is worth buying has to do with equity. I am talking about equity in the property being used as collateral. Typically, this will be a single-family home (or a building of one to four units). Equity is the additional amount the property is worth over and above the loan(s), liens, or encumbrances on it. Or, stated another way in the context of real estate: the difference between the current market value of the property and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying off all mortgages.
Here’s an Example
A home is worth $100,000.
The borrower owes a first lien of $50,000. This is a note and mortgage secured by the home. There are no other liens on the property.
In this scenario, the equity, or remaining value above the loan(s) is $50,000. So we say there is $50,000 of “equity” in the property. This $50,000 is your cushion as a lender or note owner. It helps provide that sleep-well-at-night feeling. It is no coincidence that banks look for equity when you apply for a home loan. Typically, they are looking for 15–20 percent equity in the property (often your down payment). This means they will only lend up to 80–85 percent of what the home is worth. This 15–20 percent equity protects them in the event of default, ensuring they will have enough left over to cover any attorney’s fees, real-estate agent fees, or associated items should they need to foreclose, sell the home, and recover their money.
Here's Another
A home is worth $100,000.
The borrower owes a first lien $50,000. This is a note and mortgage secured by the home. The borrower also owes a second lien of $25,000, which is also a note and mortgage against the home.
In this scenario, the property has two mortgages. Combined, the borrower owes $75,000. If the home is worth $100,000, the remaining value “left over” after both mortgages are paid is $25,000. This means there is $25,000 worth of equity in the property. In this example, we are not accounting for real-estate agent fees or commissions should the home be sold, or any attorney’s fees for a foreclosure, etc. This is simply to illustrate the equity concept. Again, this $25,000 is protection or “cushion” for the lender or note owner.
General Rule of Equity
- More Equity = More Safety for the Lender
- Less Equity = Less Safety for the Lender
Loan-to-Value and Combined-Loan-to-Value
Loan-to-Value (LTV)
This is a calculation used to evaluate risk on secured assets, typically a home mortgage. You calculate it by dividing the mortgage amount by the property’s value.
Example: John's home is worth $300,000. He has a mortgage secured by the home for $200,000. Simply divide the mortgage amount by the property value. In this case the answer is 66.66 percent. So the LTV is 66.66 percent. This means John has 33.34 percent, or $100,000, of equity in his home. This $100,000 is protecting the mortgage owner in the event of default.
Combined-Loan-to-Value (CLTV)
This is just like the LTV calculation, but it accounts for all secured loans on the property. Many homes have one, two, or even three secured mortgages on them. In these cases, it is important to know how much real equity is protecting the lender(s).
Example: Steve's home is worth $150,000. He has a first mortgage secured by the home for $100,000. He also has a second mortgage secured by the home for $40,000. He owes $140,000 total. Again, simply divide the combined mortgage amounts by the property value. In this case, the answer is 93.33 percent. So the CLTV is 93.33 percent. This means John has 6.67 percent, or $10,000, of equity in his home. This $10,000 is all that's protecting the mortgage owner—bank or note owner—in event of default.
Obviously, this is a much thinner margin of protection than the previous example and probably not enough to cover a real estate agent’s commission should the home be sold.
