If you’re investigating hard money loans, a type of private lending used to purchase or upgrade real estate, you’ve probably come across an unfamiliar acronym: LTV. We’ll take a look at what LTV is and the role it plays in lending.
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What Is A Loan-To-Value Ratio?
LTV stands for Loan-To-Value ratio. While it plays a more pronounced role in hard money, LTV isn’t unique to hard money loans. Banks also use the LTV ratio in their calculations when they write a mortgage.
Simply put, LTV is a number that represents the approximate risk of the loan to the lender. This number is expressed as a percentage. The higher the number, the greater the risk to the lender.
How Is It Calculated?
LTV is actually a pretty straightforward calculation. Simply take the amount borrowed, divide it by the value of the property, and convert it to a percentage. For example, if you’ve taken out a $100,000 loan on a piece of property estimated to be worth $140,000, your LTV would be 71%. ($100,000 / $140,000 = 0.7142.)
As that number increases, the lender takes on more risk. A lender that finances 100% of the property value is providing full financing. If the LTV climbs above 100%, the borrower is considered to be underwater. Banks will usually only offer higher LTV loans to customers with excellent credit.
The value of the property is usually determined by an appraiser, although some lenders will use a different metric. Hard money lenders, for example, may use the property’s after repair value (ARV) rather than its current market value.
What Role Does LTV Play In Hard Money Loans?
Hard money lenders use LTV to assess risk just like more traditional lending institutions. There are some small differences in how they use it, however. Because of the higher risk involved with hard money lending, the lenders have to consider the strong possibility that the borrower will default.
Whereas banks might heavily factor credit into their calculations along with LTV, hard money lenders will weight LTV substantially more than credit. Some lenders may not care about credit at all. As a counterbalance, they tend to use the equity the borrower puts into the property as a security. Effectively, this means hard money lenders will, in most cases, look for a lower LTV than a bank would.
How much are they willing to cover? The answer is a bit tricky. In addition to any background checks the hard money lender may decide to factor in, the property’s qualities will be considered. Properties in booming real estate markets and “up-and-coming” neighborhoods may push the lender’s LTV tolerance close to 75%, often considered the upper limit for hard money. In contrast, a property in a poor market, or a remote one, will push the maximum LTV closer to zero.
Similarly, the state of the property will play a large role in how much risk the hard money lender is willing to take on. The better the state of the property, the higher the LTV can go.
Remember that some lenders will calculate the LTV based on the ARV of the property. This is most likely to happen when you’re borrowing money to rehabilitate a property.
How Important Is It To Understand Your LTV Ratio?
At the risk of being evasive, let’s just say that it can’t hurt to understand how your lender is making their underwriting decisions to make sure you’re getting a good deal. On the other hand, you’ll end up seeing the LTV eventually in the form of the amount of money they offer you. The most important thing to remember is that the more the lender is willing to cover, the higher they’ve assessed the value of the property.
Hopefully this overview has given you a basic understanding of what LTV is and how it’s used in real estate transactions. If you’re looking for other options for business loans, check out our handy guide.