In Loan to Value Ratio Explained for Borrowers, we looked at how to calculate the loan to value ratio (LTV) and why it is important for borrowers purchasing a home. The LTV ratio is equally as important for investors looking to put their money into mortgages. But how does mortgage investing work? What does the LTV ratio tell us about the investment?
This guide will explain how mortgage investing works and why the LTV ratio is a fundamental concept to assess the value of an investment.
How Mortgage Investing Works
A mortgage note is a promissory note secured by a piece of real estate. Banks and private lenders sell mortgage notes to free up their cash flow. Investors who purchase them pay for the remaining debt on the notes and collect the borrower’s principal and interest payments in return. Essentially, the note buyer fills the shoes of the bank.
Buying mortgage notes can be a good investment for people who want to invest in real estate but avoid the hassles of being a landlord.
How LTV Applies to Mortgage Investing
The loan to value ratio (LTV) describes the size of a loan compared to the value of the collateral property. It represents how much equity the owner has in the property.
In the case of a mortgage note, the LTV ratio is found by dividing the amount of the mortgage by the value of the property securing it. For example, a $60,000 loan made against a property valued at $100,000 has a 60% LTV ratio.
A higher LTV ratio means a riskier investment because the borrower has less equity in the home and is more likely to default on payments. Notes with a lower LTV ratio are safer because there’s a greater likelihood that the note holder can recoup their investment if the borrower defaults. Generally speaking, an LTV ratio of over 80% is considered a higher risk for an investment.
Signs of a Safer Investment
Mortgages with large down payments or substantial equity earned through long-term ownership will have the lowest LTV ratios. Look for these signs when investing.
A borrower with greater equity has more to lose if they default on their mortgage. These borrowers are statistically more likely to make their loan payments and less likely to strategically default. Better for you as an investor!
Avoiding an Underwater Mortgage
An underwater mortgage is a home loan that has a principal that exceeds the value of the home itself. This can happen when property values decrease. For example, during the 2008 financial crisis, underwater mortgages were a frequent problem among homeowners as property values dropped substantially around the country.
When the LTV ratio of a mortgage is higher than 100%, the loan is considered underwater. Having a lower LTV ratio will reduce the risk of a mortgage going underwater if property values decrease.
To demonstrate, let’s say a borrower purchases a home for $100,000 and takes out a $90,000 loan (LTV ratio of 90%). The market suddenly takes a downturn and the home’s value drops 15%. This means the home is now worth $85,000 and the debt on the loan exceeds the property value by $5,000. If this home was sold while it’s underwater, the sales proceeds wouldn’t be enough to pay off the mortgage. The borrower would still have to cover the remaining balance.
Now let’s look at the same deal, but instead, the borrower takes out a $70,000 loan (LTV ratio of 70%). If the value of the home were to drop 15% to $85,000, the debt on the loan still would not exceed the value of the property. The lower LTV ratio would protect the borrower from going underwater.
Mortgage note investing is worth considering if you are an investor looking to diversify your portfolio. A significant factor for controlling risk is investing in a note with a low LTV ratio. Be sure to research the different types of notes available and the financial situation of the borrower before investing.
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