When discussing real estate, you often hear the phrase “Loan to Value Ratio” or LTV. The LTV ratio compares the amount owed on the mortgage to the property's appraised value. A lot of information can be extrapolated from this simple ratio, and it is crucial for real estate investors to understand exactly what it means.
What is a Good LTV?
A high LTV ratio means the property owner owes a lender a large percentage of the property value on an outstanding mortgage. An LTV of 100% indicates that an amount equal to the entire property's value is owed to a lender. Typically, the lender and borrower want a lower LTV on the property.
A good rule of thumb is that an LTV ratio of 80% is a good, safe number for both parties. Generally, this will require a buyer to have 20% cash to use a down payment on the property while borrowing the other 80%. As the loan gets amortized by making payments each month, the LTV gradually diminishes.
There is another factor besides the outstanding loan amount that affects the LTV. The property value can fluctuate up or down after a new owner purchases the property. If property values go up, that will push the LTV down. Likewise, if property values drop, the LTV will increase. It is possible for falling property values to drive the LTV above 100%. When this happens, the borrower is said to be "upside down" on loan, which is generally taken as a warning sign that the loan may default.
What can a bad LTV signal?
High LTVs, either on a single property or on an average of LTVs in a specific location, can signal dangerous overleveraging. Most lenders will require a borrower to have a down payment to go with the loan so that the entire property value is not being borrowed.
A high LTV may mean that the lender did not require a high enough down payment for the property. This can be dangerous because if the loan is too high, the monthly payment is also relatively high. On investment property, that may leave little room for error if unforeseen maintenance or repair issues need to be addressed or if the property does not generate the expected rent revenue. In such a case, the borrower may be unable to repay the loan in time.
If average LTVs in a single location gets too high, that is often a sign of a potential systemic failure leading to a financial crisis. It is important for lenders to require appropriate down payments to allow room for error and a buffer if real estate prices temporarily drop.
What are the advantages of a low LTV?
For an investor, it is important to keep LTVs on the properties they own at a reasonable level, ideally 80% or less. This signals that they have the appropriate cash reserves to make a sizable down payment on their properties and will still be able to successfully run their business if a recession occurs. Property values drop for a period of time.
Borrowers who keep a low LTV on their properties also reap benefits from better loan terms from lenders. Making a sizable down payment generally means a lower interest rate and more flexibility on other terms of the loan as well. If the down payment is large enough, private mortgage insurance is not required, lowering expenses and freeing up even more cash flow for the investor.
LTV when getting a loan approved
When applying for a loan for a home to live in or an investment property (an office, a warehouse, etc.), understanding your lenders' requirements will help you get the best possible loan terms. Having a proper down payment will not only allow you to get a more desirable interest rate, but you will also be able to handle any unforeseen economic events. Not being over-extended is a responsible behavior for lenders and buyers alike as it helps keep the overall economy healthy and safe for everyone.
