When buying an investment property or any property with a loan, a ratio will come into play, which is called the loan to value ratio. This ratio will also determine whether or not you need to pay mortgage insurance on your investment property.
The loan-to-value ratio (LTV) is one of the most important factors in acquiring a loan because it shows your equity in a piece of property. Essentially, equity conveys how much of the property you own, and is articulated simply through a percentage figure.
Think of equity as the amount of money you would receive if you decided to sell your property for its current price, minus the amount you must return to the lender in order to repay the loan. To get a clearer idea, let’s take a quick look at an example, to figure out the LTV (Loan to Value) requirements for most real estate investors.
If a property costs $300,000 and you put down $50,000, you should divide your loan amount by the purchase price:
1. Price of property: $300,000
2. Down payment: $50,000
3. Loan: $250,000 ($300,000 - $50,000)
4. Loan to Value Ratio (LTV): $250,000 / $300,000 = .83 or 83%
In this example, the loan is worth 83% of the value of the property. A high LTV means you have less equity, and lenders will view you as an extremely risky borrower who could default on a loan. For this reason, lenders will increase their costs because of the greater risk involved.
Your Loan to Value (LTV) ratio also has a few other implications that pose significant impacts on the loan process. It determines two things:Fees and amounts you’ll be charged for the loan.Whether or not you will pay Private Mortgage Insurance (PMI), and if you must use an escrow account...
Usually, if your down payment on a home is less than 20% of the appraised value or sale price, you must obtain Private Mortgage Insurance. From the lender’s perspective, PMI is a necessary precaution because it serves as protection if the borrower defaults on the loan. But on the other hand, borrowers can benefit from PMI because it makes it possible to buy a property with as little as 5% down payment. This means you can purchase a property a lot sooner instead of waiting a long time to save enough money towards a substantial down payment.Really, don't let paying PMI weigh you down when making a decision. It usually not that substantial and, as mentioned before, enables you to put less money down and not 20%. The bigger factor is how much a potential renter will pay to live in the property and what you pay for the property when you buy it.
Lenders will have different requirements to determine if a loan will be given with a certain LTV. For example, owner-occupied residences usually get loans with an LTV of 80%. But if a property is intended for investment, lenders might require higher LTVs.Once your loan balance falls to 80%, you can cancel your PMI coverage. Just keep track of your payments on the principal of the mortgage and notify the lender when the time has arrived to discontinue the PMI premiums. The Homeowners Protection Act of 1998 (which took effect in 1999) requires lenders to tell the buyer at closing how much time it will take to reach that 80% level in order to cancel PMI. Lenders must automatically cancel PMI once the balance of the loan drops to 78%.
When you cancel PMI, you’ll need a good payment history, which means that you should make all mortgage payments within 30 days from their due dates. Lenders might also ask that you provide evidence that the value of the property has not fallen below its initial value, and that you have not taken out a second mortgage (e.g. a home equity loan). In order to show proof of your property’s value, you’ll need to obtain an appraisal, which you can read about here: Qualify for the Perfect Loan.
LTV is also used if you wish to refinance a property. For instance, say you’ve owned a property for 10 years and want to refinance it to take cash out. Nearly all lenders will give you a maximum of 75% the property’s appraised value for the new loan amount. But lenders who refinance at greater than 75% will charge high interest rates.