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Private Lending (8) – What to Calculate?
Continuing from the last post, after all the underwriting, what truly matters in the end is LTV. If the results are favorable, even if there are additional debts on the property, various plumbing issues, low credit scores, or if the property is located in a remote area, which most people would immediately reject, it’s still possible to proceed with the application. Conversely, if the calculated results are unfavorable, even with a credit score over 800, a desirable property location, good property condition, and stable homeowner income, the application cannot be approved. Why is that? Let’s delve into what needs to be calculated and how.
First and foremost, we need to calculate the Loan-to-Value ratio (LTV). As a recap from the previous discussion, LTV = (current loans on the property + applied loan amount) / current market value. For example, in the previous scenario, if a property is assessed to have a market value of $1 million, the current bank loan is $600,000, and the homeowner is applying for a second loan of $100,000, then the LTV would be (600,000 + 100,000) / 1,000,000 = 70%.
However, each of the numbers in this formula can be a potential pitfall in practical application – Let’s break it down and discuss each component in detail.
Firstly, it’s absolutely crucial to obtain the exact amount of the first mortgage directly from the bank! We’ve encountered countless problems just on this one alone. Don’t trust anything provided by homeowners, brokers, etc. Only the amount directly obtained from the bank can be relied upon! Furthermore, some bank loans have special characteristics, such as the ability to directly increase the amount of the first loan without requiring secondary approval. This can increase the LTV of your second loan from 70% to over 80% without your ability to stop it, potentially leading to a loss of principal for the second mortgage! So, every word in the documents issued by the bank must be read meticulously! Your closing lawyer most likely won’t do this for you, you have to painstakingly read through every word yourself!
This also relates to the amount registered by the bank for the first mortgage on title, which sometimes may be higher than the actual amount. This indicates the possibility that the bank can increase the first mortgage amount at any time. In such cases, you must absolutely obtain written confirmation from the bank that the loan amount will not be increased. Again, you have to request it yourself, and most of the time, the bank won’t provide such a document. In such situations, no matter how persuasive the borrower and broker are, and no matter how they assure you, never calculate the LTV based on the actual amount; instead, use the larger amount registered by the bank! These are all lessons learned the hard way; don’t ask me how I know! 😂
Furthermore, if there is a first mortgage, it must not be from private lending institutions outside of the bank. Banks won’t demand exorbitant fees every step of the way; However, non-bank private lending institutions are not of the same style. They can directly inflate the cost of a standard letter to thousands, and they send them out every day. As for legal fees, management fees, and various other charges, let’s not even mention them. They can directly skyrocket the relatively low LTV of the second mortgage. What was initially a safe LTV at the time of closing might become precarious during power of sale or foreclosure, potentially leaving the subsequent creditors with nothing. Therefore, if you’re considering lending on a second mortgage, never lend to borrowers whose first mortgages are not from the major banks.
So, the first number in the formula is explained. As for the second number, for now, let’s use the amount applied for by the borrower (this is the number that will ultimately be adjusted based on final result of the underwriting process). Now, let’s focus on the denominator. The denominator is the market value, right? Generally, it’s safe to rely on the conclusion of a third-party appraisal report recognized by the bank, isn’t it?
Doing things this way will make you cry afterward, because if you lose money, it’s you who loses, not the appraisal company. This is another pitfall.
After venting, let’s get to the conclusion directly now. After encountering numerous pitfalls, our subsequent standard process involves only examining the details of the property in the appraisal report. We assess the value ourselves through paid data internally to create our own comps evaluation, preferably of the same house type on the same street. After all, they rely on producing reports for their livelihood, we, on the other hand, rely on underwriting deals properly for our livelihood. Additionally, we pay another third party for additional valuation. In other words, for any given property, we need to obtain three valuations, one of which must be our internal valuation. Then, we take the lowest of these three values as the denominator! It’s not the average value or the number on the appraisal report; it’s the lowest value!
Alright, the LTV has been calculated for now. Many years ago, we could do up to 85%, but now we mainly stick to 75% or less. If the location is remote, we either don’t do it at all, or we cap the LTV at 60% or even lower (this depends on factors such as the market value of the property, its liquidity, etc., details of which will be discussed later; for now, let’s just outline the general framework). Apart from LTV, there are two other crucial algorithms. These two things are basically not calculated by anyone, because generally speaking, if the LTV is managed well, it’s sufficient. But we’ve encountered many pitfalls, so we’ve developed these two algorithms ourselves to avoid being caught off guard in the worst-case scenario. We’ll discuss them next time.