Quite often, commercial real estate loan borrowers have to comply with the several criteria set by lenders. These can include a good credit score, annual income to be eligible for the loan, minimum down payment to be paid by the borrower, etc. Apart from this, there are also other critical criteria that tend to annual income required to be eligible for a home loan, the minimum down payment to be raised by the borrower, a good credit score, etc. Besides this, other essential criteria set by lenders is the loan-to-value ratio. Let’s have a detailed look into what this aspect is all about.
What is the Loan-to-Value Ratio?
Loan-to-value (LTV) ratio is a measure commercial real estate lenders use to determine the risk they might be taking on, with a secured loan. This ratio determines the relation between the loan amount and the asset’s market value used as collateral, maybe property or real estate.
When a lender provides a loan worth half the value of an asset, the LTV is measured at 50%. With a rise in the LTV ratio, the potential loss faced by a lender in case the borrower fails to repay increases, creating more risk. Though loan-to-value ratio can be applied to any secured loan, it is most familiar with mortgages.
Several federal mortgage programs specify the LTV limits as part of their qualifying criteria. A mortgage divided by the appraisal amount that works out to 80 percent should be sufficient to get any borrower the financing he’s looking for. However, this depends solely on the lender.
LTV ratio is a part of the property’s value that lenders can finance through a mortgage. This ratio is generally used by financial institutions such as banks, finance companies, SBAs, and non-banking finance institutions to assess their risk in lending real estate commercial loans to borrowers. LTV’s core purpose is to help lenders calculate if they lend a higher amount than the property’s actual price.
How is the Loan-to-Value Ratio Determined?
Calculating the loan-to-value ratio is a critical component in helping commercial real estate lenders determine whether the borrower is qualified to avail of the mortgage and the debt’s proposed terms. The LTV can be calculated as:
LTV= Loan Amount / Appraised Valuean LTV Formula
Banks and SBAs are most concerned with the LTV ratio at the time the debt amount is issued. But LTV can be calculated any time during the loan’s repayment period. It is done by dividing the amount owed on loan against the property’s appraised value. As and when the borrower begins repayment, the amount owed by him decreases, which lowers LTV. In case the value of a property increases over time, this also plays a crucial role in reducing the LTV. However, a dip in the property’s value can prove detrimental for the lender as it can increase the loan-to-value ratio.
When an LTV ratio is higher than 100%, then the property’s market value to lesser than the loan’s balance and a borrower is considered to be “underwater” on loan. The value of an LTV can also be higher than 100% during the repayment period on loans with high closing costs.
Importance of Loan-to-Value Ratio
The higher a borrower’s LTV ratio, the riskier he’ll appear to the bank or SBA, during the mortgage’s underwriting process. When a low down payment is made on the loan amount, the borrower has less equity in the property and is likely to default on it. Hence lenders follow stringent measures when providing higher loan amounts.
How Does Loan-to-Value Ratio Affect Interest Rates?
Lenders in the US have a typical practice called risk-based pricing that includes setting higher interest rates on loans they feel are relatively risky. This leads to borrowers with lower credit scores being charged more than those who have excellent credit. This method applies to LTV as well: since a higher LTV ratio spells more risk to the lender, loans with high LTVs generally come with higher interest rates.
LTV Ratios in Commercial Real Estate
Loan-to-value ratios are applied in commercial real estate as well. However, banks and SBAs require LTVs lower than 80 percent when a property is intended to be an investment. It is one of the three primary ratios that commercial lenders typically use to determine a borrower’s credibility.
In this instance, the market value of a property is often based on its commercial appraisal, but in the case of residential properties, the purchase value is used, if it’s low. The mortgage is divided by the appraisal amount, calculating up to 80 percent. This should ideally suffice to get the required amount; however, this entirely depends on the lender.
As a general rule, commercial lenders don’t approve loans that have LTVs higher than 80 percent. But there are a few lenders who provide non-conforming mortgage programs that tend to go higher than the determined value. In the case of residential real estate, a lower LTV ratio is usually aligned with more favorable loan terms and rates.
How to Lower Your LTV
To reduce the loan-to-value ratio on loans, especially on commercial real estate mortgage loans, the borrower has to mean lower total costs over the duration of the loan. There are only two variables that determine this ratio: the loan amount and the asset value. Here are two ways to reduce the LTV ratio:
Larger down payments are considered an ideal approach to lowering the loan-to-value ratio percentage. Even though saving for that big down payment can be a testing phase, it is always worth the shot, given its long-term benefits.
Availing a loan should be set on more affordable targets. This will not only help in reducing the loan-to-value ratio but also reduce the burden during repayment.
Typically, loan-to-value ratios for commercial real estate loans are set at 75% or 80%. A maximum LTV of 75% may be allowed for real estate, while an LTV of up to 80% is generally acceptable for multifamily construction. However, off late, many commercial mortgage lenders and intermediaries have created many non-conforming commercial loan programs that offer 90% commercial financing.
One must remember before borrowing a loan from a commercial lender that lower the LTV ratio, the favorable it is for other terms and interest rates on the commercial mortgage. Every lender will calculate the LTV ratio when the borrower applies for a loan. With a lower LTV ratio, you can quickly negotiate with your lender for lesser interest rates and higher tenure of loan repayment.