Borrowing money probably seems easy if you’ve never done it. But in reality, it can be pretty complicated. Every borrower who has applied for that first mortgage knows this all too well. For example, one of the things that catches many first-time borrowers off guard is what is known as the loan-to-value (LTV) ratio.
LTV is a principal utilized for all sorts of lending. Banks apply it to first and second mortgages. They apply it to small business loans. Even hard money lenders look at LTV when determining how much to offer borrowers. Ultimately, LTV determines how much a borrower can get in relation to how much is needed to make a deal.
A Percentage of the Total
The easiest way to understand LTV is to view it as a percentage of the total amount you need. Let us say you are looking to buy a house with a $100,000 price tag. Your lender expects you to make a 20% down payment. Why? Because their LTV is 80%.
Should you purchase that house, the total value of the deal will be $100,000. The bank’s LTV dictates that it can only lend you $80,000. You have to make up the remaining 20%, or $20,000. This is an oversimplification of the LTV principal, but it explains the idea well enough.
Banks and hard money lenders utilize LTV for several reasons:
- To spread the risk between themselves and the borrower
- To ensure they do not a loan too much
- To force the borrower to put some skin in the game.
The last point cannot be understated. It actually encapsulates the previous two. Lenders want borrowers to put some of their own money in because it minimizes lender risk and helps to protect lenders from overextending themselves. If lenders do not require borrowers to put skin in the game, it is a whole lot easier for them to default.
LTV’s Vary Among Lenders
Another thing first-time borrowers don’t usually know is that LTVs vary among lenders. In the mortgage market, LTVs can be anywhere from 75% to 90%. The higher the LTV, the higher the interest rate. There is also PMI (mortgage insurance) to consider. Any LTV over 80% requires the borrower get PMI to protect the lender in the event of default.
Hard money lenders operate a bit differently. According to Actium Partners out of Salt Lake City, UT, LTVs on hard money loans tend to be lower. Rarely will a hard money lender go as high as 90%. Usually, it is between 50% and 75%.
Fortunately, hard money lending is asset-based lending. This means that lenders approve loans based on the strength of the borrower’s collateral rather than their promise or demonstrable ability to pay. With that being said, a property investor looking for hard money to acquire a piece of land will not need to get PMI regardless of the LTV. It is just not something that hard money lenders require.
100% Funding Is Rare
The one thing all first-time borrowers should understand is that 100% funding is rare. Whether you are buying a house, purchasing a new car, or even investing in your very first rental property, count on your lender requiring you to make a down payment. That is what LTV is all about.
The lender will only fund a certain percentage of the total amount you need to complete the transaction. You make up the difference with a down payment. How you obtain a down payment is up to you. In some cases, you have to demonstrate that you already have the money in hand before your loan will be approved.