Loan-to-Value Ratio When Buying Property
What Is the Loan-to-Value Ratio And What Does It Have to Do With My Interest Rate?
When you start looking into real estate investing, you will surely come across the term loan-to-value ratio sooner or later. It doesn't matter whether you're looking at investment properties or looking to buy a home. However, it's also one of those real estate terms that isn't self-explanatory to newbies.
That's the exact reason why we should definitely start talking about it now. The loan-to-value ratio is what the bank uses to estimate the risk of lending you money for your property purchase. It's also why the loan-to-value ratio impacts your interest rate, and subsequently, your monthly rate as well as your cash flow and the profitability of your property investment. In this article, we want to show you how it all works, what the lending value exactly is, how to define the lending limit and how to calculate the loan-to-value ratio. 💡
- Loan-to-Value Ratio
- Lending Value
- Lending Limit
- Calculation
- Impact on Interest Rate
- Improving the LTV
- LTV & Subsequent Financing
What Is the Loan-to-Value Ratio?
The loan-to-value ratio defines the relationship between your mortgage and the value of your property you intend to finance. In a way, it's a kind of risk assessment tool for the bank that you are asking for financing.
It's always displayed as a percentage, so the lending amount and the value of the property. If you are using multiple loans to finance your property, they are added together. The basis of your loan-to-value ratio is the lending value of your property.
What Is the Lending Value?
The mortgage lending value is the amount that the bank uses to calculate the loan-to-value ratio of your mortgage. But be careful: You shouldn't mistake the lending value with the purchase price of your property—the lending value is always lower. The lending value is the assumed price that the bank would be able to achieve in a sale at any given time.
The lending value is usually between 80-90% of the purchase price. That assures that the value of your property will surpass the outstanding debt, should you fail to make due at some point. And because all good things come in threes, we'll also talk about the lending limit.
What Is the Lending Limit?
This is a term commonly used in banking. The lending limit is the maximum percentage of the lending value up to which they can provide you a loan. The lending limit is therefore not equal to the lending value, although it does depend on it.
The lending limit depends on the market value of your property. The market value can vary depending on market fluctuations. To cushion exactly these risks, a certain discount is applied to the mortgage lending value to determine the lending limit. The lending limit is meant to reflect the value that can be achieved at any time if the property were sold. For real estate loans, the lending limit is set at 80%.
Calculating the Loan-to-Value Ratio: Here's How
So how do you calculate the loan-to-value ratio anyway? It's actually pretty easy. Since the loan-to-value ratio is the percentage of the lending value of the property that the loan amount covers, you simply divide the loan amount by the lending value. You then multiply the result by 100 to get the percentage.
Here's what that looks like as a formula:
Loan amount / Lending value x 100 = Loan-to-value ratio
Example of a Loan-to-Value Ratio Calculation
Let's say you want to buy an apartment for 100K Euros and want to use 40K Euros of your equity, therefore borrowing 60K from the bank. If we assume that the bank will deduct 10% of the purchase price to determing the lending value, you get the following calculation:
60,000 / 90,000 x 100 = 67%
With a loan-to-value ratio of 67 % you are below the lending limit. If you use more equity, your loan-to-value ratio decreases. If you should use more or less equity depends on your situation but our experts are always ready to help you figure that out.
What Does “60% Financing” Mean? Loan-to-Value Ratio & Interest Rate
The terms “60% financing” or “80% financing” indicate what percentage of the property you are mortgaging and how much equity you are contributing. A 60% financing means you are borrowing 60% of the property’s value, while an 80% financing means you are borrowing 80%. With 60% financing, you naturally need to contribute more equity than with 80% financing. In return, you benefit from a better interest rate.
This is what makes the loan-to-value ratio such an important concept in real estate. The interest rate is crucial in determining your monthly payment and whether the deal is financially worthwhile for you. And because the loan-to-value ratio reflects the level of risk to the bank, banks generally offer better terms when the loan-to-value ratio is lower.
After all, the bank earns money from your real estate financing and is, of course, interested in minimizing risk. There is always a possibility that borrowers may someday be unable to make their payments. In such a case, the bank has the security of being able to sell the property. The smaller the share of the loan amount compared to the mortgage lending value (your purchase price minus roughly 10 to 15%), the easier it is for the bank to recover your outstanding balance through the proceeds of a foreclosure if necessary.
How to Improve the Loan-to-Value Ratio
To understand how you can improve your loan-to-value ratio, let’s take another look at the calculation.
First, there’s the loan amount. If the loan amount decreases, the loan-to-value ratio naturally goes down as well. So you could contribute more equity. However, the purchase price also plays a role. With smaller properties, it often happens that your loan amount becomes too small: most banks only finance amounts starting at €50,000 or €75,000. In that case, you would need to switch to an installment loan—and those are more expensive. And if you don’t have available equity anyway, that option is off the table.
But don’t worry! You can still finance a property without any equity. How does that work? 👇🎧
You can also adjust the mortgage lending value. As you now know, banks usually set this value 10 to 20% below your purchase price. That’s because they calculate conservatively to protect themselves. But where do you have leverage? In the price negotiation!
If you manage to negotiate the purchase price so that it’s as close as possible to the bank’s mortgage lending value, the loan-to-value ratio decreases. And in the current market environment, it’s finally possible again to negotiate property prices. How to do that successfully? We’ll tell you here. 🎧💡👇
Loan-to-Value Ratio in Follow-Up Financing
Now you know what the loan-to-value ratio is and how it works. So far, though, we’ve only talked about its role when buying a property. But what happens when your fixed interest period ends and you’re looking for follow-up financing? Do the loan-to-value ratio and the mortgage lending value still matter?
Yes, they do. In principle, everything works just the same as with your initial financing. The loan-to-value ratio is still the bank’s key risk indicator and is calculated exactly as described above. However, there is still something you should pay attention to. It makes a difference whether—after your fixed interest rate expires—you choose a prolongation or follow-up financing with a new lender. Not quite sure what the difference is anymore? Have a listen here. 👇
With a prolongation, you simply extend your existing financing with your current bank under updated terms. When you secure a new loan with a different bank, this is called follow-up financing. From the perspective of the loan-to-value ratio, the latter is clearly more advantageous. The reason is that your current bank does not reassess the value of your property when you prolong your loan. A new bank, however, will carry out a fresh valuation. Over 10 years, assuming an inflation rate of 2%, that alone amounts to a difference of about 20%. This naturally affects the loan-to-value ratio—and therefore the interest rate of your follow-up financing.
What Does This Mean for My Property Purchase?
Well, that depends. One thing is certain: the loan-to-value ratio plays an important role. However, that doesn’t mean that a high loan-to-value ratio is a dealbreaker for your real estate investment. You have various ways to improve it. And even if that doesn’t work and you remain above the lending limit, a property investment can still make perfect sense.
It all depends on your individual situation. But our experts will find the perfect-fit financing solution for you.