Loan to Value or LTV is a simple calculation which takes into account the appraised market value of a property, and the amount that has been borrowed, typically by way of a mortgage.
Loan To Value is expressed as a percentage. We simple take the amount of the mortgage and divide by the appraised market value of the property.
For example, if we take a property with a market value of £300,000 and the mortgage against it is £240,000, then we divide 240,000 by 300,000 and we are left with a Loan to Value of 80%. Ownership of a property, or rather the finances that create that ownership, are usually divided between two major figures – one’s mortgage – the amount owned by the lender, and what one actually owns, referred to as equity.
In our example, the homeowners have £60,000 in equity, and it’s this figure, along with the LTV, which act as key criteria for lenders and other financial institutions when it’s time to sell a property, release some equity, or borrow additional funds against the property.
So Why is LTV important?
The importance of Loan to Value can be explained in terms of risk. In this instance, we are looking at two rather polarised circumstances – positive equity and negative equity.
Over the lifetime of a mortgage, the outstanding value of the loan decreases. Of course, there are some people who took out interest only mortgage, where the outstanding amount never actually decreases – only the interest is paid off and at the end of the term, the full amount needs to be repaid.
However, over the course of the past ten years, it has become increasingly difficult, perhaps even impossible to secure an interest only mortgage. The risk to the banks is simply too high – the loans were taken out on the premise that the rising value of the property and other investments would make it easy for the full amount to be repaid in 20-25 years.
Now, with an uncertain global economy, lenders are simply not prepared to take the same risks. Borrowers are typically put onto a simple repayment mortgage and therefore, like any loan, the outstanding balance steadily decreases, and this instantly increases the equity, until such time as the homeowners clear their mortgage and have 100% ownership and equity in their home.
So what is Negative Equity?
Let’s take an example of a £250,000 with a Loan to Value of 80%, so a mortgage of £200,000. All in all, that would appear to be a sensible investment for the bank and a comfortable arrangement for the home owner.
Now from Post War Britain up until the modern day, the value of real estate has, on the whole, steadily increased. Indeed many people bought homes in the 1960s and 70s with a mortgage of what is now less than 2 months’ salary for many people!
However, economies are cyclical and house prices have seen drops from time to time. Our £250,000 home could (and indeed has on more than one occasion) dropped to an appraised market value of £200,000 – this is a 100% Loan to Value.
If it dips further, then the value of the mortgage exceeds the value of the property, forcing the owners into negative equity.
Is Negative Equity a Problem?
In the long term, it is possible to simply weather the storm and wait for confidence to return to the housing market and thus eventually drive the value of the property back up to it’s original figure of £250,000 and then beyond. But of course, there are many that would argue that this is an over simplistic and, at the same time, optimistic viewpoint. They would not be wrong, so let us consider the bigger picture.
As long as the homeowners don’t need to leverage their home to raise additional capital, then their negative equity simply becomes academic. Except that life has a nasty way of surprising us sometimes, and there may well be a point where a large amount of money needs to be raised fairly quickly. In the days of rising equity, re mortgaging was common practice.
The trouble is that this property is at 100% LTV – there’s simply no equity to be leveraged against the home, and the banks are acutely aware that the value could drop even further, thus sending this home into negative equity.
That’s simply too high a risk for the banks to consider, and this has put many families into financial hardship, unable to finance major expenses like a son’s university education or a daughter’s wedding, for example.
Sadly, there is more. Let’s say that our homeowners discover that an alternative lender is offering a fantastic new rate. The smart thing to do here would be re mortgage, except the majority of lenders will not offer 100% Loan to Value mortgages any more. This means that they are stuck with their current lender, and if that same lender were to raise interest rates, then there’s simply nothing our homeowners can do to get out of it.
So How Do I Lower My Loan to Value?
The recommendation to first time buyers is to build up a sizeable deposit by saving from as early as possible. Portioning off a set percentage of income can be a great way to save, and with good discipline, 10% of the purchase price of a first home is achievable – not easy, and certainly not quick – but achievable.
Once that deposit is there, home buyers should consider being realistic about their property needs. Taking a practical example, Joanne is saving to buy her first flat. She has a good job but does work quite long hours. She has managed to save £30,000 and is looking for a two bedroom property, and has been advised that those start in her area at around £285,000, so she is in a strong position to apply for a 90% Loan to Value mortgage.
However, does Joanne really need that second bedroom. When asked what she would do with it, she simply tells people it will be a ‘spare room’. Yet there are one bedroom flats in her area with prices starting at £200,000, which would give Joanne an 85% LTV.
This might not seem like such a massive difference, but it does mean that Joanne is likely to be able to apply to even more lenders and therefore negotiate the best rates for her first mortgage.
In addition to that, should prices start to drop, Joanne has given herself more equity from the outset so it would take longer, if the worst should happen to the market, for her to see herself in negative equity. Thus she would have had time to speak with her mortgage advisor to prepare for the best course of action.
And perhaps most importantly, Joanne is that one step owner to 100% home ownership. She has saved herself around £85,000, but of course she had budgeted to pay for a mortgage of £255,000, so she can take the balance and overpay on her monthly mortgage payments, increasing the equity even faster and dramatically lowering the number of years it will be before Joanne is 100% mortgage free.
How Else Can I Improve my Loan to Value
Remember that the calculation of loan to value is a simple one – value of mortgage divided by APPRAISED value of property. Clearly, that word ‘appraised’ carries a lot of weight.
Keeping a property in good condition is about so much more than just being house proud! Let’s take another example. Two houses are purchased in the same street within a week of each other. Both of them were in a similar state of repair and both sold for £200,000.
After ten years, the owners of the first property are looking to sell. They’ve looked after their home. They’ve redecorated each room at least once and have modernised the kitchen. Estate agents put a valuation on the property of £325,000.
The same estate agent then takes a look at the second property, which has not been looked after nearly as well. Only one room has been decorated and the garden is looking rather unsightly. The estate agent values this property at £295,000.
The irony is that the owners of that first property didn’t spend an additional £30,000 on modernising their home. Decorating totalled some £7,500 and the new kitchen was £5,000. They enjoyed looking after the garden themselves so the expense there was in the region of £1,500, and yet that additional expense of £14,000 was actually worth more than double that, and consider as well that this figure has been spent in total over the course of ten years.
The value of a property comes down to the appraised figure – taking into account comparable properties in the area and the state of their décor, so looking after a home is a great way to boost one’s Loan To Value figure.
The Benefits of a Low Loan to Value Figure
Whilst we have highlighted a number of the benefits of a low LTV, one that we have not yet mentioned is the interest rates offered by the major lenders. On the whole, applying for a mortgage with a lower LTV will attract a lower interest rate.
The immediate benefit here is obvious – lower monthly payments, but what may not seem immediately obvious is that this can be a way for people to save thousands of pounds on their mortgages, simply by overpaying.
If the monthly budget has allowed for a mortgage payment of, let’s say £600 per month and a lower interest rate drops that figure to £500, then continuing to pay £600 per month will take an additional £1200 off of the outstanding mortgage each year. Plus of course, the LTV is dropping at an exponential rate, which will make it easier to apply for even better rates when it comes time to re mortgage again.
Mortgage Insurance
The banks and major lenders have all recognised that raising 20% or more of the purchase price of a home in Britain today is incredibly difficult for a lot of people. The banks themselves are keen to offer mortgages – they want to help people get onto the property ladder because for most lenders, it’s the product that gets them life long loyalty from their customer base. However, Loans to Value mortgages in excess of 80% are still considered risky.
Fortunately, there is a solution. Lenders will factor in a mandatory Mortgage Payment Protection Insurance – MPPI. For those concerned about reading the letters PPI – bear in mind that this product is not missold – the lender is legally obligated to point out to the borrower that it is a requirement of the loan that the insurance is in place.
It’s taken as an additional payment to the borrowers’ monthly mortgage payment and gives peace of mind to both borrower and lender that, should the loan become problematic for the borrower, that it will still be paid.
Should borrowers be looking to take out a mortgage with a Loan to Value in excess of 80%, it’s worth noting that other forms of insurance are available. Income Protection, Critical Illness Cover and Life Insurance policies may well all come with premiums that are lower than the MPPI being proposed by the lender, so it’s worth investigating.
It’s also worth keeping a close eye on one’s current Loan to Value. The insurance is usually only a mandatory requirement when the LTV exceeds 80%. On a repayment mortgage – the most popular mortgage available today, the Loan to Value figure will eventually dip under that 80% barrier, at which point the borrower can choose to cancel their insurance policy, and once again, can use that money to overpay their monthly mortgage payment and ultimately reduce their mortgage term.
Ultimately, one’s LTV is their bargaining chip. It’s a number which shows the bank just how much, or hopefully how little risk there is on their part for financing what is, for most people, the single biggest investment of their lives.
