By: Yara Zakharia, Esq.
One of the criteria that mortgage lenders take into account before approving a mortgage is the loan-to-value ratio (LTV). The LTV is defined as the relationship, in percentage form, of the amount of money loaned by a bank to the value of the collateral pledged as security for the loan. For instance, a $66,000 loan on a $100,000 home would have a loan-to-value ratio of 66 percent. Either the appraised value or the sale price, whichever is lower, is the property value referred to in calculating the loan-to-value.
The reason why loan-to-value is of such importance to lenders who are qualifying individuals for a mortgage is because of the risk of default. The lower the equity, the more likely that a lender will have to absorb a loss in a foreclosure proceeding. Loan-to-value indicates to the lender whether potential losses resulting from default may be recovered by selling the asset.
The higher the loan-to-value ratio, the more stringent the qualification guidelines for certain mortgage programs. Borrowers of high loan-to-value loans (an LTV higher than 89%) might be required to purchase mortgage insurance to protect lenders against default, which raises the costs of the mortgage.
The bank's acceptable loan-to-value ratio will depend on the type of collateral offered as security for the loan. The loan-to-value ratio can change from one lender to the next, and it may also be subject to other lending criteria. For example, a healthy cash flow on the part of the borrower may lead to more flexibility on the part of the lender vis-à-vis the loan-to-value ratio.
Community banks will typically offer the following LTV ratios for the different collateral listed below:
1. Real estate: Property that is occupied will yield up to 75 percent of the appraised value. If the real estate is improved, but not occupied, borrowers can expect up to 50 percent. For vacant and unimproved land, borrowers could receive 30 percent.
2. Inventory: For ready-to-go retail inventory, lenders may offer up to 60-80 percent of the appraised value. By contrast, the component parts and other unfinished goods that constitute a manufacturer's inventory might yield only 30 percent. The defining element here is the inventory's merchantability, namely, how rapidly and for how much the inventory could be sold.
3. Accounts receivable: The older the account, the lesser its value. Other elements potentially impacting the loan-to-value ratio are the account debtor's creditworthiness and delinquencies in the accounts.
4. Equipment: For new equipment, banks might advance 75% of the purchase price, whereas used equipment will likely yield a smaller percentage of the liquidation value.
5. Securities: Borrowers can obtain up to 75 percent of the market value for stocks and bonds used as collateral. However, they cannot utilize the loan proceeds to buy additional stock.
In sum, equity is a function of the LTV ratio. Understanding the loan-to-value concept is crucial for borrowers since lenders prefer a borrower to have as much equity as possible. Equity also determines how much a bank will allow you to refinance your property for and how much it will lend you for a second mortgage.
