About Loan-to-Value Ratios

Next to the credit score and quality of a borrower, the loan-to-value of the real estate being financed is the most important consideration for a lender. The lower the loan-to-value, the higher the equity position of the borrower and the less likely they are to risk a default on the mortgage loan.

Function

Loan-to-value (LTV) displays the equity (ownership) percentage of the borrower and the relationship of the requested loan to the fair market value (FMV) of the subject property (the real estate being financed). For example, if the property being financed is appraised (valued) at $200,000 (FMV) and the loan request is for $150,000, the LTV is 75 percent (150,000 divided by 200,000). This indicates that the borrower has a 25 percent ownership in the property and the lender will finance 75 percent of the FMV.

Considerations

A borrower often wants to have the highest LTV possible in a purchase situation, as they will need to put less money down on the property, thereby conserving their cash. Lenders desire a reasonable "balance" (typically 80 percent loan and 20 percent equity) to feel secure that the borrower won't risk their 20 percent equity through default, and also help recover the balance of their loan should they conduct a "short sale" (selling the real estate at below its market value) after a foreclosure.

Significance

The LTV ratio is a significant component in real estate financing, whether residential or commercial. It's interesting that such an important factor in all mortgage financing is based on opinion and not hard fact. Licensed appraisers compare the subject property and recent sales (usually within the prior six months) of identical or very similar properties to publish an "opinion of value." In periods of rising values, their estimated FMV may be low shortly after the report is completed. When values are decreasing, their FMV may quickly become high, causing some problems with mortgage loans.

Misconceptions

Many people fail to understand that an LTV is a subjective estimate, not a strong numerical percentage. Since the FMV is one person's opinion, the resulting LTV may or may not be very accurate. Additional misunderstandings sometimes arise when borrowers become annoyed that lenders are hesitant to make loans on the full FMV of a property. FMVs and LTVs provide no "guarantees" that the values and percentages will continue to be accurate in the future as the market changes.

Effects

During periods of real estate price stability, LTVs are an excellent indicator of property values and the positions of both borrower and lender. The borrower knows the value of his/her ownership percentage, while the lender understands their percentage (and relative risk) of financing in the property. During periods of declining real estate values, apparent LTVs can become inaccurate. When this occurs, the borrower's equity decreases while the lender's risk increases, making both parties unhappy.