Understanding Loan-to-Value Ratio

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If you want to succeed at Commercial real estate investing and want to make some serious money in doing so, getting your loan-and-lenders game right is so important.

Knowing what type of loans suit different commercial real estate investing needs and knowing exactly who’s the best lender in the town for you to get your loan sourced from are the major determining factors which will decide whether or not you will succeed with your real estate investing endeavors.

Most successful real estate investors agree that real estate investing is not only about finding the right properties or landing the best deals, but it’s a lot about making timely decisions about when to invest or divest and who to source your loans from.

Therefore, understanding how the lending works in commercial real estate is the most basic home works you will be expected to do.

What are some things lenders considering before deciding to fund your loan?

Not all loan applications are approved and even when a loan is approved, not all lenders are willing to cover a major portion of the loan amount. What does this mean to you as an investor and a borrower?

First – you need to hunt around for a lot of commercial real estate loan lenders in order to get the best deals, and it’s important to find the right lender who is willing to fund your loans.

Many real estate borrowers tend to give up at the face of rejection from a couple of lenders. Remember to not give up and know that you will always find someone who is interested to fund your deals, only that you must know to look in the right places.

Second – You must be willing to bring in some percentage of investment in the form of down payment, so you will almost always have to count on your savings or hand loans from friends and families, to get you started with real estate investing.

Now, what percentage of the amount you will be needed to bring in? The answer to this depends on the kind of lender you choose to work with. Lenders use, what is Loan-To-Value ratio to determine whether or not they will fund your deals.

This blog is an outline on the Loan-To-Value ratio and you will understand everything from – What is LTV? How to calculate LTV? The relevance of LTV in real estate and all about what is a good loan to value ratio and what is not.

Read on to dive into an in-depth understanding of what Loan-To-Value Ratio.

What is the Loan-To-Value Ratio?

Loan-To-Value Ratio is a value that lenders and financial institutions use for the assessment of lending risk factor, and determine whether or not to approve an impending loan approval request put forth by a real estate borrower.

This ratio is used by any party who is willing to lend money and it surely is one of the major determinants to approving a loan request. In a general scenario, a loan with a higher Loan-To-Value ratio means these loans are of higher risk to lenders and hence, they will cost higher for the borrowers in order to cover up for the high risk being taken on part of the lenders or lending institutions.

On the other hand, loans with lower Loan-To-Value ratios means lower risks for lenders and are hence less expensive in terms of loan costs for a real estate borrower.

Important note to borrowers here is that typically, in case of a higher LTV loan, borrowers are needed to apply for mortgage insurance in order to cover up and offset the high risk taken by the lenders.

So, this cost is a significant portion in the calculation of overall estimated costs for a borrower to get a loan approved.

How to calculate Loan-To-Value Ratio?

The LTV formula to calculate the Loan-To-Value Ratio is quite simple to understand and calculate. Loan-To-Value Ratio is calculated by dividing the total mortgage loan amount by the appraised value of the home or the purchase price of the home.

For example: Let’s say the purchase price of your property is $2,00,000 and the mortgage loan amount you are looking for is $1,80,000. So, the LTV ratio for your loan would be 90%. In a nutshell, LTV ratio is the loan amount divided by the appraised value of a property, expressed as a percentage.

Therefore, the amount you are ready to pay as the down payment determines your LTV ratio and your chances of getting your loan approved.

And as said earlier, loans with higher LTV ratios mean higher risk for lenders, and so – it’s always important that you have enough money in the form of savings or reserves or hand loans that is necessary to complete a certain percentage of down payment, so that more lenders are willing to finance your deals.

For instance, let’s say the purchase price for your property is $2,00,000 and you have made the down payment of $40,000. You now need your lenders to fund you the extra $1,60,000. So, the LTV ratio for this loan would be 80%. And now, as compared to the previous example where the LTV ratio was 90%, the chances that lenders would be willing to fund your deals is much higher.

As a thumb rule, lenders like to work with borrowers whose LTV ratio is no greater than 80%. There may be few exceptions to this rule, depending on the individual lender you are working with and the scale of your investments.

Typically, a savvy commercial real estate investor who has been around in the game of commercial real estate investing since a while has a greater chance of getting good deals even when the LTV ratio is high as compared to the ones who are just starting out as an investor.

And the obvious reason for this would be a big reputation this commercial real estate investor has made for himself in the market for many years.

The credibility of such savvy investors would be very high, thus leaving lenders feeling more secure with their lendings.

So, unless you’re a savvy investor with a great reputation in the market, it is important for you to try and accumulate a good portion of the total purchase price of your property, to bring in as a down payment, so that your LTV ratio boils down to a percentage less than 80 and you have a fair chance of getting your loan request approved without any hassles.

What is a good Loan-To-Value Ratio?

There is not an exact number that justifies being called as a “good” Loan-To-Value Ratio. As a matter of general thumb rule, lenders and traditional lending institutions consider Loan-To-Value ratios that are lesser than or equal to 80% to be a good ratio. The lower the ratio, the better it is for the lenders and the higher the chances of you getting the loan approved.

What are the factors contributing to Loan-To-Value Ratio?

The three key factors contributing to determining the Loan-To-Value Ratio are:

  • Down payment, you are bringing in to purchase the property
  • Loan amount of the mortgage you are looking to get the funding for
  • The total purchase price of the property

Loan-To-Value Ratio = Loan amount of the mortgage ÷ The total purchase price of the property

What does it mean to have a lower Loan-To-Value Ratio?

A lower Loan-To-Value Ratio typically means:

  • For a lender – that the risk invested in the loan is lower and thus, the lenders are more forthcoming towards providing loan to borrowers. 
  • For a borrower – that the down payment needs to be higher and thus, a solid saving or reserves or hand loans needs to be arranged for. Lower LTV means that the greater the chance of your loan to get approved.
  • When the Loan-To-Value Ratio is lower, the rates of interest for the loan would be lesser too. This means that the overall cost of the loan for a borrower would be lesser.
  • In case of a lower Loan-To-Value Ratio, since there is less risk on the part of lenders, the borrower will not be needed to purchase private mortgage insurance.

Why do lenders prefer lending loans that have lower Loan-To-Value Ratio?

Understanding why lenders or commercial real estate lending institutions prefer to lend loans that have lower Loan-To-Value ratios helps you be prepared to the questions you may be asked or to make arrangements with respect to bringing in better down payment while negotiating loan terms with the lender and convincing lenders to fund your loans.

The major reason why lenders prefer a lower Loan-To-Value Ratio especially with borrowers who have just ventured into the commercial real estate investing business is that – a higher LTV means that the equity of the borrower into the property is much lesser, meaning that in the event of foreclosure of the property, it is a huge burden on part of the lender and should the borrower default on his loan repayments or go bankrupt, the onus of finding a suitable buyer for this foreclosed property is now on the lender.

This is the reason why lenders like to work with borrowers who have lower LTVs where the lenders are assured of a fair percentage of equity in the property.

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