Financing is a highly critical aspect of real estate investing. In fact, the profitability of your real estate investment depends greatly on your ability to obtain favorable loan terms. It goes without saying that getting good financing is predicated on having a good grasp of several metrics and concepts, the foremost of which is the loan to value ratio. So what is the loan to value ratio in real estate? How to calculate loan to value? And what is a good loan to value ratio? This article will delve into these questions and discuss every aspect of LTV in real estate.
Definition of the Loan to Value Ratio in Real Estate
The loan to value ratio is an assessment tool that evaluates the risk of lending. Mortgage lenders use it when processing investment property loans. Naturally, a high LTV in real estate signifies a higher risk from the lender’s point of view. As a result, these investment loans will be more costly for the borrower and might even require getting mortgage insurance. Here are the main implications of LTV in real estate:
- The loan to value ratio can be the determining factor between getting approved for a mortgage or not.
- LTV in real estate determines the amount of down payment that you have to put toward the income property.
- A low loan to value ratio gives you access to the lowest investment property mortgage rates that the lender offers.
The Factors That Impact LTV in Real Estate
As it is the case with every real estate metric, the loan to value ratio is impacted by several variables. Let’s take a closer look at the two most consequential ones.
1- The down payment on investment property
The most significant factor that can affect your loan to value ratio is the amount of down payment that you are willing to pay. The higher the amount is, the lower your LTV will be. The impact of a large down payment cannot be overstated since it invariably leads to quick loan approval and low-interest rates. Furthermore, you won’t have to buy private mortgage insurance (PMI).
2- The appraised home value
The home appraisal is an integral part of determining the loan to value ratio. This is essentially a process that seeks to verify to what extent the contract price reflects market value. Assessing the value of an investment property involves comparative analysis as well as a look at a wide range of housing market conditions. In some cases, the home appraiser might even recommend certain repairs before proceeding with the loan.
Calculating Loan to Value in Real Estate
The loan to value formula is fairly simple. In fact, it only employs two variables: the mortgage amount (MA) and the appraised home value (APV).
Loan to Value Ratio = MA/APV.
The result is expressed as a percentage and the lower it is, the more favorable the terms of real estate investment loans will be.
The loan to value ratio calculation is used in a wide array of real estate investments. Whether it is buying a rental property or refinancing an existing mortgage, the lender will always impose stricter terms on any investment that has a high loan to value ratio.
Now that you are familiar with the concept of LTV in real estate, let’s delve into what constitutes a good loan to value ratio.
What Is a Good LTV?
The general rule for the loan to value ratio is that lower is better. However, the ideal ratio depends on which type of loan you are applying for. Here are the minimum LTV requirements for each type of loan.
1- Conventional loans
These are the most common types of loans for real estate investing. For most mortgage lenders, the ideal loan to value ratio is 80%. This is due to the fact that most conventional loans require a down payment of around 20%.
2- FHA loans
FHA loans are mortgages that are backed by the Federal Housing Authority. Compared to conventional loans, these government-insured mortgages give real estate investors more leeway. For example, you can get loan approval with an LTV as high as 96.5%. However, this requires you to have a credit score of at least 580.
3- VA loans
VA loans are special mortgages that are exclusively available to service-members, retired service-members, and some surviving military spouses. Since these loans don’t require any down payment, you can qualify with an LTV of 100%. Having said that, you still need to meet several criteria that pertain to income and military status.
4- Mortgage refinancing
The LTV requirements for refinancing vary depending on which lending entity the real estate investor works with. For example, refinancing a mortgage through the FHA comes with no LTV limits. On the other hand, going through the Home Affordable Refinance Program (HARP) means you will be subject to the same 80% minimum that conventional loans require.
Other Variables to Keep in Mind When Applying for a Loan
While highly important, the loan to value ratio is not the only variable that comes into play when securing a mortgage. You still need to make sure that your other financial aspects are in order. Some of the factors that lenders will look at when processing your loan application include income, credit score, employment history, and debt to income ratio.
The Bottom Line
Given its use as a leading risk assessment tool by mortgage providers, a low loan to value ratio should be the goal of every real estate investor. Start saving for a down payment and tidy up your finances in order to meet your lender’s criteria and get the best possible loan terms.
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