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Understanding The Commercial Loan To Value Ratio

For the uninitiated the factors involved with the decision of whether or not to lend money, and at what terms, can seem random and hard to fathom, but in most cases these lending decisions break down into three important ratios. The ratios with which every potential commercial borrower must become familiar include:

  • Debt Service Coverage Ratio (DSCR)
  • Debt Ratio (DR)
  • Loan to Value Ratio (LTV)

Of these three factors, it is the last ratio, the loan to value ratio, or LTV, which is the most important in terms of underwriting. The loan to value ratio is defined as shown below:

LTV Ratio = Total loan balances (including all mortgages) / the fair market value of the property

In order to understand this ratio and what makes it so important, it is important to take a look at all the factors that make up the ratio, starting with the first number. If the commercial or residential borrower is taking out a first mortgage or loan, and there are no other loans on the property, the beginning balance of the new loan being requested will be the numerator.

If, on the other hand, the borrower is applying for a second mortgage, the underwriter will add the sum of the first mortgage and the amount of the proposed second mortgage to arrive at the numerator. If the borrower is applying for a third mortgage, the proposed amount of that third mortgage would be added to the existing amounts of the first and second mortgage loans.

In cases where there is an existing mortgage on the property, and the borrower is applying for a second or third mortgage, the loan to value (LTV) ratio is sometimes referred to instead as the combined loan to value, or CLTV, ratio.

The second part of the LTV ratio is of course the fair market value of the property being financed. This number is arrived at via an independent appraisal, with one important exception. That exception occurs when the proceeds of the mortgage loan will be used to purchase the same property that is being used to secure the loan. That type of mortgage is known in the industry as a purchase money loan, and in cases where the appraised value is lower than the purchase price the lender will use the lower amount in order to calculate the LTV ratio.

While the potential lender will of course calculate the loan to value ratio at the time of the loan application, it is a good idea for potential borrowers to calculate their own loan to value ratio prior to applying for a residential or commercial mortgage on a property. The exact requirements and rules for borrowing will of course vary from lender to lender, and from property to property, but having a rough estimate of the LTV will give buyers a better understanding of the entire underwriting process, and a head start in the world of residential and commercial lending.

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