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Understanding Loan-to-Value Ratio

Lenders use specific ratios to determine whether they will approve a commercial real estate loan. One of the main ratios used during this process is known as loan-to-value (LTV). If you understand how it is calculated and why it impacts the likelihood of having your request approved, you can navigate the lending process with greater ease.

How to Calculate the Ratio

LTV measures the relationship between property value and value of the loan requested. It is calculated by dividing the loan amount by the appraised value of the property. Generally, a higher LTV ratio will result in a higher interest rate for an approved loan, as the borrower is considered riskier. A low LTV ratio signifies that there is more equity in the property and that the borrower is less likely to default on the loan. This may qualify the borrower for a lower interest rate. Commercial lenders vary in their specific requirements, but most expect to see that a borrower will pay 20% or more of the purchase price.

As an example, a business that is asking for a loan in the amount of $700,000 to purchase a property appraised at $1,000,000 would have an LTV of 70%. This signifies that the loan will cover 70% of the property’s value, and there will be a deposit of 30% of the value. It is important to use the appraisal value, as lenders will require that that there is support for the purchase price. They will use the lower of the two amounts to calculate the LTV if the appraisal value and purchase price differ.

Why Lenders Use Loan-to-Value Ratio

In order to calculate the maximum loan amount for a property, lenders apply the required LTV to its value. In the case of a property valued at $2,000,000, a lender allowing a 75% maximum LTV would approve a maximum loan of $1,500,000. The ratio also is used to determine the interest rate that will be offered. Since properties with a high LTV are considered riskier, they may not be able to secure the best interest rates available from a conventional lender.

The LTV expectations associated with conventional loans differ from those that are approved by the U.S. Department of Housing and Urban Development (HUD) and insured by the Federal Housing Administration (FHA). HUD-approved lenders are able to approve loans with a higher LTV and offer more aggressive rates due to this insurance.

How the Ratio Affects Loan Amounts

During the application process for your loan, three ratio tests will be used: loan-to-value, debt-service coverage, and debt yield. The loan that you receive must satisfy all three ratio tests. While application of one ratio may lead to a higher maximum loan amount than the others, the amount that is approved will be a more conservative amount.

By calculating LTV, it will be easier to understand how lenders will view your request. The ratio factors heavily into the decision of whether to approve a commercial real estate loan as well as the rate and terms that will be available. Expectations are similar, but they vary by lender based on their objectives for each property type.

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