What is a Loan to Value Ratio?
If you are obtaining a mortgage, you may feel overwhelmed by the jargon that comes with the territory. From affordability to equity, it can be a bit daunting trying to understand what terms mean.
This article explains one such term, Loan to Value. We get to grips with how loan to value is calculated, what lenders use it for and how it can affect your mortgage application. Let’s jump in.
What is Loan to Value (LTV)?
Loan to Value is the amount you are borrowing vs the value of the property you are purchasing as a percentage. Lenders will calculate your loan to value when assessing whether the mortgage presents a high risk to them. Lenders operate a cut off point where a loan to value ratio is too high risk and they will not lend.
For example, you will find it impossible to obtain a mortgage of 99% of the property value. Historically, lenders have been comfortable with 95% mortgages, but with the property market in decline currently, these products are being offered less frequently.
You may see mortgage products offering 0% deposit such as the Family Springboard mortgage. In truth, these mortgages still have a deposit amount which is typically 10% of the property value held in a savings account and linked to the mortgage.
Why is Loan to Value So Important?
Loan to Value is important to lenders as it allows them to gauge how much risk a mortgage presents. The higher the Loan to Value percentage, the greater the risk. This is because if the property market has a downturn, you could find yourself in negative equity. This is where the amount you have borrowed exceeds the property value. Lenders are concerned about negative equity because it can make recouping the full value of the loan difficult if they repossess the property.
Repossession is treated as a lender’s last resort and only occurs when you have failed to keep up with mortgage payments.
It is a legal process that involves the lender taking back the property and selling it to recover the money owed on the mortgage. Most lenders will use an auction to sell the property quickly.
With negative equity scenarios, a lender will not be able to recoup the cost of the mortgage because the value of the property is below the mortgage amount. In these circumstances a lender makes a loss – which is why there is risk for high loan to value mortgages.
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How is Loan to Value Calculated?
To calculate a Loan to Value ratio the lender will take how much you are borrowing and subtract it from the value. For example, if you are borrowing £180,000 on a £200,000, the amount of deposit will be £20,000.
The loan to value ratio is the percentage difference between the two values. The lender calculates how much percent the loan is to the value. In this example the loan is 90% of the value. The deposit amount is 10% of the property value and therefore you would hold 10% of the equity from outset.
Does LTV Affect Interest Rates?
Yes, your interest rate is the result of various factors including Loan to Value. The interest rate charged will correlate with the risk profile of the case. A low interest rate is a low-risk product whereas higher interest rates represent higher risk products.
With Loan to Value, the more you are borrowing against the property value, the higher the risk and the higher your interest rate is likely to be.
It is for this reason you will find that mortgage deals with 10% deposits have better interest rates than mortgages with 5% deposits overall.
What is a ‘Good’ Loan to Value Ratio?
A good loan to value ratio is one where the lender has little risk lending to you. The greater the amount of deposit you can put down the less you will need to borrow. Having a lower borrowing amount relative to the property value represents less risk to the lender.
There is no golden rule with loan to value ratios and each lender assesses their risks independently. A good general rule is the less you need to borrow against the property value the less risk your mortgage is to a lender.
With Buy to Let mortgages, the loan to value threshold for lenders is typically much higher. For example, a lender may ask you to put at least 25% of the property value down as a deposit. The Buy to Let industry represents more risk to lenders than the residential mortgage industry, due to the risk of rental voids, and they ask for higher deposits to mitigate some of this risk.
Finally, there is no risk-free mortgage product. Lenders are always taking some risk when offering mortgages. Loan to Value ratios are a way for lenders to limit that risk to some degree, not eradicate it entirely.
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How Does LTV Affect Remortgaging?
Loan to value normally impacts remortgaging in a positive way. If you have a 5-year fixed rate deal, for example, you will have made repayments on your mortgage for five years. Those repayments build up the amount of equity you hold in the property.
By the time you come to remortgage this increased equity should improve your loan to value ratio and represent less risk to a lender. You might find your remortgage deal has a lower interest rate as a result.
Negative Equity and Remortgaging
However, there are difficulties if the property market has a downturn and house values fall. In some circumstances you may find you have little or no equity in the property when you remortgage. If this happens you will need to put a further deposit down on the property to remortgage to take the loan to value ratio past the acceptable threshold for a lender.
If you find yourself in negative equity during your mortgage deal, it is always best to plan ahead and speak to a mortgage broker to find out what your options are.
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Boon Brokers is a Whole of Market Mortgage, Insurance and Equity Release Brokerage. We provide fee free advice and can assist if you are struggling with the loan to value on your mortgage. Contact us today to book your free consultation with one of our dedicated mortgage advisers today.