Hard money lenders make use of loan-to-value (LTV) ratios just like retail banks. But they do not necessarily use LTVs the same way. That being the case, here is a secret you might not know: it is possible for a borrower to actually get a higher loan amount from a hard money lender despite that lender offering a lower LTV.
The Basic Principle
The basic principle of the LTV is as simple as understanding the amount of money being borrowed as compared to the value of the property in question. Let us use some easy numbers to keep this simple. Imagine a lender with a 50% LTV. You want to buy a property valued at $100,000. At 50%, the lender offers a $50,000 loan.
Lenders rely on LTVs to limit their risk. By only lending a certain value of the property at hand, they force the borrower to put some skin in the game. A borrower required to invest a significant amount of cash is less likely to risk that cash by defaulting.
How Banks Do It
Here in the U.S., banks are bound by federal regulations. Those regulations stipulate that banks must base their LTVs on the lower of two numbers: fair market value and sales price. Let’s look a bit more closely at each one:
- Fair Market Value – Fair market value is the value of a property based on current market conditions. It is generally calculated by conducting an appraisal that includes comparing the property against similar properties nearby.
- Sale Price – Sale price is the price that buyer and seller agree to when signing a sales contract. It can be higher or lower than the fair market value depending on the deal the two work out.
By law, banks must look at both numbers and then base LTV on the lower of the two. If the agreed sale price of a property appraised at $150,000 is $100,000, LTV would be calculated using the sale price. At 50%, the maximum loan would be $50,000. But if the sale price were higher than fair market value, LTV would be applied based on the latter.
How Hard Money Lenders Do It
Hard money lenders are regulated at the state level. Therefore, they are not required to follow federal regulations. Most states allow hard money lenders to determine LTV in whatever way suits them. My understanding of hard money is that lenders typically base LTV, and loan approval by the way, on fair market value.
Actium Partners, a hard money lender located in Salt Lake City, UT, explains that basing LTV unfair market value makes it possible for an investor to secure a larger loan through a hard money lender even though its LTV is lower than the bank’s. Actium also explains that hard money lenders can offer LTVs as low as 50%. So how could an investor wind up with a larger loan? Think distressed properties.
Distress Equals Lower Sale Price
A distressed property is one that is already in foreclosure or being offered on a short sale to avoid foreclosure. Sale prices on distressed properties tend to be much lower than fair market value. So because hard money lenders can base LTVs on fair market value while banks are tied to sale price, a hard money loan could actually be worth more even with a lower LTV.
Though this sounds confusing, it is nonetheless true. LTVs in hard money are such that they can actually be a boon to borrowers who wouldn’t be able to get as much money from a bank.
