The loan-to-value ratio (LTV) is a measure related to mortgages that lenders use as a measurement of financial risk. Namely, because it determines the amount of funds a bank is willing to loan (how much financial risk it’s willing to take) to finance an investment. All of which, of course, is important to the real estate investor because it decides the amount of funds that can be borrowed against the investment (amount of leverage), the cash down payment required, and in turn the amount of financial risk to the investor. Let’s look at the calculation and then consider a couple of examples.
Loan-to-value is the ratio of the debt to the actual value (commonly the lesser of the appraised value or actual selling price) of a property. To calculate it, divide the loan amount by property value. For example, let’s assume you want to purchase a condo rental income property for $300,000 and can borrow $210,000. Your loan-to-value would be 70% (loan amount / value = loan-to-value; or 210,000 / 300,000 = 70%).
Example one. Suppose the lender informs you that they require a 70% loan-to-value. What are they telling you? Namely, that they will accept 70% of the financial risk (or $210,00 worth of risk; 300,000 x .70 = 210,000), and require you to accept the other 30% (or $90,000 worth of risk; 300,000 x .30 = 90,000).
Example two. The bank reconsiders and decides it wants a 60% loan-to-value. In this case, because they are willing to fund only $180,000 (300,000 x .60 = 180,000) it means they have determined to take less of a financial risk (they will lend less), and in turn want you to take more of the risk (you will have to put more cash down).
Okay, now consider the two examples and decide which loan-to-value (the higher or lower ratio) gives the real estate investor the better leverage (use of borrowed funds to finance an investment). Of course, a 70% loan-to-value (the higher of the two ratios) gives the investor the better leverage because it means he or she can purchase the investment with more of the banks money, less cash of its own, and in turn shift more of the financial risk on the lender.
