CHAPTER 32
Calculation 26: Loan-to-Value Ratio
What It Means
Loan-to-value ratio (LTV) is the ratio between the total amount of a property’s mortgage financing and the property’s appraised value or selling price, whichever is less. It is expressed as a percentage.
If the selling price is indeed less than the appraised value, the lender will base the LTV on the selling price. You will be tempted to argue that you negotiated a terrific deal, that you are buying below market, and that the lender should use the higher, appraised value in the LTV calculation. If you prevail, be sure to call a press conference because you will be the first investor ever to win this argument.
If you were to purchase a home as a personal residence, the maximum LTV (i.e., the most the bank would lend you) would typically be 80% for a conventional mortgage. To put this another way, you could borrow 80% of the value or purchase price. Private mortgage insurance and government programs such as FHA and VA are available to assist homebuyers, making it possible for you to purchase a home with an LTV approaching 100%. This author bought his first home many years ago with an FHA loan and a 1.5% down payment (98.5% LTV).
For investment property, however, you will often find that lenders expect your equity investment to be greater. Eighty percent is possible, but don’t be surprised to see the LTV requirement at 70% or lower. There are at least two reasons why lenders want a lower LTV when financing investment property:
1. They do not want to have to take over the property in foreclosure and operate it while they try to sell it.
2. They don’t want to lose money.
In regard to the first reason, the lender will usually be forced to take over the property if the borrower decides to walk away. This generally happens when the borrower runs into financial problems and can’t make the payments. With a personal residence, it is usually the loss of personal income that is at fault. With an investment property, however, the problem could lie either in the owner’s personal finances or in the building’s failure to produce adequate cash flow.
One of the purposes of lending less than the full purchase price is to provide a disincentive for the borrower to abandon the property. In the case of a personal residence, the bank knows that if you default and go into foreclosure, you’re going to have to clean out your sock drawer and move your family into a motel. A major life disruption is a strong disincentive to bail on your mortgage.
In the case of an investment property, the lender (having apparently read this book) knows that the property is all about the numbers, and in particular, the cash flow numbers. If your cash flow were to go up in smoke, you would need a good reason to prevent you from dropping the keys off at your nearest savings and loan branch. That reason is your equity stake in the property. The more of your own money you have tied up in this property, the less likely you are to give the property back to the bank.
The second reason the lender prefers a low LTV follows from the first. The lower the mortgage balance stands in relation to the property’s value, the greater the likelihood that the lender will recover all it is owed and thus not lose any money in the event of a foreclosure. A corollary to this principle is that the ease with which you can obtain financing for a property is in direct proportion to the size of your own cash investment. The more you have at risk, the less the bank has at risk.
How to Calculate
Loan-to-Value Ratio = Loan Amount / Lesser of Property’s Appraised Value or Actual Selling Price
Example
1. You are purchasing an income property for $500,000. You will put down $150,000 and finance the rest. The bank’s appraisal comes in at $500,000. What is the LTV?
First, you have to calculate the loan amount:
Loan Amount = Purchase Price less Down Payment
Loan Amount = $500,000 less $150,000
Loan Amount = $350,000
Then, you can apply the preceding formula. The selling price and the appraisal are the same, so you use $500,000 as the property’s value.
Loan-to-Value Ratio = 350,000 / 500,000
Loan-to-Value Ratio = 70%
2. You are purchasing an income property for $550,000. You will put down $150,000 and finance the rest. The bank’s appraisal comes in at $500,000. What is the LTV?
First, calculate the amount of the loan:
Loan Amount = $550,000 less $150,000
Loan Amount = $400,000
Now apply the formula. (Note that you use the appraised value, which is lower than the selling price.)
Loan-to-Value Ratio = 400,000 / 500,000
Loan-to-Value Ratio = 80%
3. You are purchasing an income property for $500,000. You will put down $150,000 and finance the rest. The bank’s appraisal comes in at $550,000. What is the LTV?
First, calculate the amount of the loan:
Loan Amount = $500,000 less $150,000
Loan Amount = $350,000
Now apply the formula. (Note that this time, you use the selling price, which is lower than the appraised value; you always use whichever is lower.)
Loan-to-Value Ratio = 350,000 / 500,000
Loan-to-Value Ratio = 70%
The lower the LTV, the better your chances are of negotiating favorable loan terms.
Test Your Understanding
You are purchasing a property for $400,000 and plan to put $120,000 down to satisfy your lender’s requirement for a 70% LTV. However, the appraisal comes in at $375,000. You still want to go ahead with the deal. To what amount must you increase your down payment?
Answer
First, determine what the lender will use as the property value. It must be the lesser of the purchase price or the appraised value, so the lender will use $375,000.
Next, take the formula:
Loan-to-Value Ratio = Loan Amount / Property’s Value
and transpose it so that you can solve for the loan amount:
Loan Amount = Property’s Value × Loan-to-Value Ratio
Loan Amount = 375,000 × 0.70
Loan Amount = 262,500
Finally, subtract the loan amount from the actual purchase price to calculate your required down payment.
Down Payment = Purchase Price less Loan Amount
Down Payment = 400,000 less 262,500
Down Payment = 137,500
Instead of the $120,000 you were planning on, this lower appraisal will make it necessary for you to put down $137,500.