The term mortgage comes into English from Middle English, Old French, and ultimately Latin and can literally be taken to mean “death pledge.” However, unlike its etymology suggests, a mortgage is but another form of debt involving two major parties, the lender and the borrower. Taking on a mortgage can be a frightening and frustrating endeavor because the borrower feels completely out of control and at the mercy of the lender who determines not only whether the money will be lent but also the interest rate the borrower must promise to pay to secure the loan.
There is much talk today about credit scores and their relation to the ability of a borrower to qualify for credit. Not surprisingly, borrowers with lower credit scores often pay higher interest rates to compensate the lender for taking on riskier debt. However, credit scores are transitory; they change as the borrower’s situation changes. The riskiness of a mortgage, nothing more than long-term debt lasting twenty to forty years, cannot be determined alone by the borrower’s current credit score, a number likely to fluctuate change over the life of the mortgage.
Debt, Interest, and Riskiness
What makes mortgages different from other types of debt is the length or maturity of the loan. A lot can happen in say thirty years so lenders must calculate whether the debt is worth it and determine the interest rate that will compensate the lender for the riskiness of the loan.
Interest rates are determined on what is called the term structure of interest rates. Essentially, this mean that as the maturity (end of the debt’s life) increases, so must the interest rate to compensate the lender for the risk associated with the loan not being paid back. The longer the maturity, the more likely something will happen and the borrower will default on the loan. However, the amount of money borrowed also determines the loan’s riskiness. This makes sense because the more a person borrowers, the less likely he/she will be able to pay it back. Ask yourself, which is riskier, lending $10 to someone for a day or lending $100,000 to someone for thirty years? Both the length of time and the amount borrowed determine the riskiness of debt.
Loan to Value Ratio
In determining the riskiness of a loan, lenders often look to ratios and other calculations to guide decisions. Each loan is in itself a small project with its own unique conditions, limitations, and variables that make mortgage loans especially a process involving many complex factors. Two major factors underlying this process are the principal value of the debt and the total value of the underlying asset. To speak more plainly, the two main factors are the amount of the mortgage at the time of the loan and the value of the property purchased with the mortgage. The Loan to Value Ratio (abbreviated LVR) is simply the division of the mortgage amount (numerator) by the property value (denominator) and can be express as:
LVR = Mortgage Amount / Property Value
It is essentially the mortgage amount as a percentage of the property value purchased with the mortgage. Say, for example, that a person wants to take out a $100,000 mortgage to buy a house and the land on which the house sits. The official appraised value of the house is $150,000. Then, the LVR can be calculated as:
0.6667 = 100,000 / 150,000
The mortgage amount expressed as a percentage of the property value is about 67%. Were the value of the property appraised at $120,000, the LVR would be:
0.8 = 120,000 / 150,000
and we could say that the mortgage amount expressed as a percentage of the property value is 80%.
Discrepancy between Mortgage Value and Property Value
Without getting deep into legal or financial areas, there are two main reasons why the mortgage and the property value differ. First, buyers of a house often pay cash as a down payment on property. This serves two purposes. Sometimes a mortgage lender will require such a payment to satisfy the terms of the mortgage, a risk-reducing requirement. This down payment also reduces the total amount borrowed thereby reducing the risk of the mortgage to the lender and the interest rate paid by the borrower.
Second, it is possible that the property is being sold under what it is worth. This may occur when one appraiser’s estimate of the property value differs from another appraiser’s. This can also occur when the seller is willing to sell the property for less that it is worth. He/she may wish to buy another house and needs the proceeds from the sale of the property to move forward with the purchase. Perhaps the property was on the market for an extended period of time and the seller just wants to move on and is willing to take this loss. Either way, the Loan to Value Ratio is a way of examining this discrepancy regardless of its reason.
Often, the best estimate of the value of property is the amount it sold for in a recent sale (less than two years). Sometimes lenders consider the price negotiated between the buyer and seller as the best estimate of the property’s value. For long-standing ownership, valuing property can be complicated given changes in the property itself, market fluctuations, and the value of property beyond just what is sitting on the land as in the case of a developer needing to buy adjacent land to expand a business.
How Mortgage Lenders Use the Loan to Value Ratio
As discussed above, the two major aspects of a loan that determine its riskiness is the amount of the debt and the length of time until the debt matures. If the maturity of the debt is held constant, then the major determining factor of the riskiness of the mortgage is the amount borrowed. This simple case will help illustrate the usefulness of the LVR.
Low LVRs are those that fall under the 80% mark. These mortgage loans are the least risky for the lender and carry with them the lowest interest rates. Again, the interest rate is a measure of the debt’s riskiness; the lower the risk, the lower the interest rate. Lenders consider LVRs above 80% risky and carry with them higher interest rates to compensate for the additional risk associated with default on the loan. The riskiest mortgage loans are those where the LVR is 100%. These mortgage loans are those where the buyer takes out a mortgage for the full value of the property. The buyer in this case is not putting any of his/her money toward the purchase of the property. Lenders typically reserve these types of mortgages for buyers with extraordinary credit ratings (low debt/high assets) and a proven record of paying back debt on time and in accordance with the terms of the debt. Most would consider this type of debt foolish on the buyer’s part since even a small amount up front, say 5% to 10%, would greatly reduce the risk borne by the lender and therefore reduce the interest rate significantly.
In the United States, mortgage loans are carefully regulated since the amount of time and money involved are significant for both the lender and the borrower. Only LVRs at 80% or below are in line with Fannie Mae and Freddie Mac guidelines. Borrowers need to secure mortgage loans involving LVRs above 80% with mortgage insurance due to their riskiness. The situation becomes more complicated when one considers second or even third mortgages. These situations involve great riskiness for both the lender and borrower and represent special cases that fall under heavy regulation.
The Loan to Value Ratio is a calculation of mortgage debt as a percentage of the value of the underlying property. Lenders use this ratio as a method of determining the riskiness of the mortgage loan. The risk associated with any loan is used to determine two things. First, it answers whether the loan is a good risk, i.e. should the lender extend the loan to the borrower in lieu of lending the money to another borrower. Second, the riskiness of the loan determines the interest rate the borrower must pay to make the risk borne by the lender “worth it.”
As can be expected, the Loan to Value Ratio is but one calculation made by mortgage lenders. Many other factors besides this one ratio determine whether the lender extends a mortgage loan to a borrower. However, a few simple calculations such as this can help a potential borrower understand the loan from the lender’s point of view.