Loan To Value Ratios, Refinancing, and New Loans (Mortgage Basics)
Most of us who have owned our own home for a while have had plenty of exposure to mortgage loans. But every year there are millions of new entrants into the housing market who have little knowledge of the mechanics of mortgages and the vernacular employed.
So, I’ll be writing some posts on the basics of mortgages, with the intention of tying all these concepts together over the next 4-5 months into one giant index of mortgage information. To be sure, this stuff exists (to some extent) on other places on the web. But, I enjoy the topic, so your stuck with it. Please weigh in with your own ideas… And dont’ worry, it won’t consume the whole blog (or even most of it) 
To get us started, I’ll tackle a relatively simple concept: Loan to Value Ratio. In future articles, we’ll discuss more complex issues like credit reports and scores, security instruments, reverse mortgages, closing costs, and more. So, without further ado…
Loan to Value Ratio (LTV)
At its core, the Loan to Value ratio is a simple math equation: the value of the first mortgage on a home divided by the total value of that home. It is a measure of risk that lending institutions use to decide whether or not to provide a mortgage to a prospective borrower.
For example, if a home is appraised at $100,000, and the first mortgage on the property is $80,000, the LTV ratio is $80,000 / $100,000 = 80%.
Why the Loan to Value Ratio Matters
In a mortgage, the property is collateral for the loan. If a borrower fails to make payments (called defaulting), the lender has the right–through a structured legal process–to take the home and sell it to recover their costs on the property. LTV is a “backstop” ratio that ensures that the lender is fully covered in cases of default. In other words, the lender has assurance they’ll be able to sell the property and recover their investment.
Requirements for Refinancing and New Loans
In the United States, the two largest mortgage loan buyers, Fannie Mae and Freddy Mac, will purchase conforming loans with a LTV ratio of up to 80%. As a result, most lenders today require a first mortgage loan no higher than 80%. For higher LTV ratios, the borrower can purchase private mortgage insurance (PMI), an insurance policy that pays the lender for losses in the event of a default. So, why is 80% the standard LTV ratio for Freddy and Fannie?
The answer is, to a degree, a political one. 80% is what the Government requires Freddy and Fannie to require. An 80% LTV ensures that at least 20% of a home’s value is reserved to account for the following items in the case of default:
- Decline in overall property value due to a housing slump.
- Past-due interest on the loan.
- Selling costs (including Realtor and transaction fees).
- Repairs on the property to bring it to code / make it sell-able.
- Back insurance / insurance during transfer.
- Back taxes / taxes during transfer.
What if You Don’t have 20% Down?
An alternative for high LTV situations is to take out a second loan or a home equity line of credit (a HELOC) to make up the difference between the 80% first mortgage amount and the remaining amount required to purchase the property.
From 2001 – 2006, second mortgages and HELOCs were an easy and inexpensive way to make up a deficit in down payment.
Recent LTV Requirements for New Mortgages
As the housing market has fallen over the last 3 years, mortgage lenders have placed increased emphasis on LTV. Today, obtaining a second loan or HELOC can be extremely difficult, with many lenders only loaning up to a total combined LTV of 85%. (Meaning, that the second loan can be no more than 5% of the total value of the home).
There are still options for new homeowners, including FHA and VA loans that can sometimes provide 100% financing, as long as the borrower pays PMI and, in the case of the VA, meet certain qualifications.
Recent LTV-related Refinance Issues
The housing collapse has also put many existing homeowners in high LTV positions. In the worst cases, people are underwater in their mortgages. In essence, people in these situations can become trapped in their current mortgages. New lenders may be unwilling to take on the risk of a high LTV property, even though interest rates may be much lower.
In a falling housing market, it is extremely important for homeowners to keep an eye on the value of their properties. If your property falls below an 80% LTV situation, you should work hard to pay down the property to the 80% level in order to keep refinancing options available.
What do you think? Did I miss anything in the analysis?
(Photo: kansas_city_royalty)
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2 Responses to Loan To Value Ratios, Refinancing, and New Loans (Mortgage Basics)
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April 21st, 2009 9:07 am
One thing to keep in mind is that if you’re trying to refinance your mortgage right now, the government’s “Making Home Affordable” program should allow people to refinance up to 105% of their home’s value. In theory. Many people are finding it harder in practice to actually get their mortgage company/servicer to follow through on it. I’m working on a refinance right now as well, and it is a bit tough trying to get them to do anything..
April 21st, 2009 9:20 pm
BMM – Great Point… We recently wrote about the Making Home Affordable Program, but I had written this article before reading that one (which was actually written by Ethan).
Here’s the Link: Making Home Affordable