Wealth-Building Power Math: LTV (Part 5)

Wealth-Building MathBuilding WealthLearn to Invest

Jun 20

Image sourced by Daniel Thomas @soy_danielthomas

LTV or Loan-to-Value Ratio or is often one of the most overlooked financial formulas; a foundation of finance, business, investing and managing risk.

Simply put, you can use the Loan-to-Value Ratio or LTV (formula) to help you analyze the risk-reward framework in a financial transaction or an investment.

One of the most common examples is a real estate investment.

Perhaps you own a home or are looking to buy a home:

Hopefully the bank will lend you money – a mortgage. The bank’s credit underwriting decision largely depends on your net worth, your income (salary and bonus) and investment income and your credit rating. These items demonstrate your ability (capacity) to repay a debt.
The bank requires you to make a down payment, typically 10% or 20% of the purchase price.
For ease of discussion, let’s assume the house costs $100 – that’s 100% of a number – the purchase price of the house which equals the fair market value of the house.
Down payment:

If you make a deposit or down payment equal to 10% of the purchase price, your down payment equals $10 (10% or 0.10 multiplied by $100 purchase price).
Instead, if you make a deposit or down payment equal to 20% of the purchase price, your deposit equals $20 (20% or 0.20 multiplied by $100 purchase price).

The bank lends you the balance – extends a mortgage.

With your 10% deposit or down payment, the bank would lend you 90% of the purchase price or $90 ($100 fair market value minus $10 equals a $90 loan). And. . .
With your 20% deposit, the bank would lend you 80% of the purchase price or $80 ($100 fair market value minus $20 equals an $80 loan).

The Loan-to-Value Ratio or ‘LTV’ gives you a framework to analyze the risk in a financial transaction or an investment.

The LTV gives the value the asset or investment can lose (decline) before the lender loses any money.

In the case of the house, for a moment let’s sit in the lender’s shoes. . . If the house is worth $100 or 100% and the market value of the house declines by:

10% or $10, the fair market value is now 90% of the original fair market value of $100 on the day you purchased it or $90. And instead, if you make a down payment equal to. . .
20% or $20 the fair market value is now 80% of the original fair market value of $100 on the day you purchased it or $80.
In both of these examples, ignoring selling costs, the lender can still recover all of its money by selling the house to a third party.
Note though, these examples ignore any repairs and maintenance costs and transaction costs including selling commissions, taxes and transfer fees that the lender may incur if they foreclose on the property and sell it to a third party.
Using the LTV, with the 20% down payment the lender (bank) has a bigger cushion or margin of safety. In other words, the value of the house could decline by 20% or $20 before the lender loses money, at least in theory.
When my ex-wife and I purchased a house – the marital residence, we put down (made a down payment) of only 10% of the purchase price of the house. Since we didn’t make a 20% down payment, the bank required us to carry ‘Private Mortgage Insurance’ or ‘PMI’. The private mortgage insurance or PMI reduced the risk or mitigated the risk that the lender assumes given that our down payment was lower. And the bank’s margin of safety or cushion in the event the fair market value of the house declined and we defaulted (didn’t pay) on the loan was lower. Fortunately at some point, given market appreciation (increase) in the value of the house and the principal we amortized (paid down) through our monthly debt service payments, our equity exceeded 20% of the market value of the house. So we were able to cancel the private mortgage insurance (PMI). The PMI premiums increased our cost to carry (own) the house and therefore our effective interest rate.

If you’re looking to buy a home, you can work towards saving money to make the down payment, improve your credit rating and build your net worth.

Now that you understand the Loan-to-Value ratio or LTV ratio, you can use it to assess your risk, make more informed investment decisions, manage your asset allocation and manage your risk.

See you next week.

Arthur V.

P.S. To Save More Money Every Day – click here.

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Disclaimer: OH and Please Remember, we are Not financial advisors, financial planners, attorneys or accountants and are Not providing any specific financial, tax or legal advice here. Be sure to conduct your own due diligence and consult your own professional advisors to get sound professional advice that’s specific to your financial and personal circumstances, risk tolerance, time horizon and investment goals and objectives among other key factors!