Promissory Notes – Understanding Loan to Value
If you are considering investing in promissory notes, you’ll want to understand the loan-to-value ratio or LTV. But what is LTV? What is it used for? How can you make sure you have an LTV that fits your investment strategy and goals? Keep reading to find out, then contact the team at iPlanGroup to learn more about promissory note investing with your self-directed IRA.
What is LTV and What is it Used for?
LTV is the value used by financial institutions prior to approving a loan. Specifically, LTV is used to assess a potential borrower’s level of risk when they apply for a new loan or line of credit. Generally speaking, a high LTV indicates that a borrower is a higher risk, meaning the lender has a higher chance of not recouping their money. This means a borrower’s loan would likely be more expensive (i.e. have a higher interest rate) to carry than that of a borrower with a low LTV.
LTV is an important metric when evaluating promissory note lending, including mortgage notes and trust deeds. For investors, just as with banks, a high LTV means higher risk. In the event the loan defaults because the borrower couldn’t pay it back, a high LTV makes it less likely that you’ll recoup the entire loan amount in the sale. On the other hand, a lower LTV means the risk for loss is much lower.
How to Calculate LTV
To calculate loan-to-value ratio, a simple mathematical equation can be used:
Loan-to-Value Ratio (LTV) = Mortgage Amount / Appraised Value of the Property.
Here is what that would look like in real life: Assume a customer has an appraised property worth approximately $200,000. Because of a recent kitchen renovation and landscaping improvements, they are mortgaged for $250,000. The LTV on the property would be 125%. On the other hand, if the same customer were only mortgaged at $100,000, LTV on the property would only be 50%.
How LTV Affects Promissory Note Investments
As we discussed in our article, What Happens if a Borrower Defaults on a Promissory Note?, when a borrower defaults, the IRA that owns the promissory note is then fully responsible to collect or foreclose on the note. For this reason, it’s crucial for promissory note investors to go into the transaction fully understanding their level of financial risk and with the intent and system to use best practices.
Choosing investments is always a gamble; there is no surefire way to know how well an investment will do in the future. By choosing promissory note investments that have a lower level of risk, however, investors can mitigate the risk of the overall investment.
That means choosing promissory note investments that have an LTV commensurate with your long-term investment strategy. A younger investor with many years of income ahead of them might decide to take a more risky approach, whereas an older investor with few working years left may decide to only take on promissory notes that have a low level of risk for a potentially higher ROI.
Is a Promissory Note Investment Right for You?
To learn more about promissory note investments with your self-directed IRA, or to learn how LTV might affect your investments, schedule a strategy session with the team at iPlanGroup today.