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Loan to value ratio or LVR is nothing short of a buzzword in the mortgage market. It might sound a little daunting with words like ‘value’ and ‘ratio’ in it, but it is not really all that bad. It is an easy concept that has an immense effect on the borrowing power of a person. Let’s dismantle it today.
What is Loan to Value Ratio?
Let’s get the definition out of the way first. So, what is LVR? As the name suggests, LVR is the ratio of the loan amount to the value of the security or property. It is the amount of money you need from the lender divided by the value of the property as assessed by the lender. It is usually presented as a percentage.
Let’s say you want to buy a home priced at $600,000. You already have some funds lying with you that add up to approximately $150,000. Hence, you need to borrow only $450,000. Here is what your LVR will look like.
LVR = (450,000/600,000)*100 = 75%
Understanding your LVR
Is the purchase price of a property always the same as the value assessed by the lender?
No, it is not necessary that the price at which the property is purchased is the same as the value of the property ascertained by the lender. For instance, if you are buying a property in a rapidly growing neighbourhood, it could be experiencing a surge in prices. So, it is possible that the property value changed after you reached a deal with the previous owner. Another scenario in which the two prices may differ is when people buy a property from their relatives. It is possible that their relatives may have given them a discounted price than the actual price of the asset.
If it so happens that the two values differ, then the lender will use the lower value to determine LVR. The very concept of LVR is to minimize the risk of the lender. A lower value will give them the worst case-scenario and hence help in taking the safest decision.
As in the example above, an LVR of 75% is generally good. In fact, an LVR of up to 80% is usually fine when it comes to the lenders. But, if your loan requirement crosses the 80% mark, you will be looking at costlier loans. Why is that? Because a higher LVR represents a higher risk.
With the 75% LVR, the lenders know that you have the finances to fund 25% of the purchase. You have higher equity in the home and that makes you a safer borrower. As for the lender, they need to lend you a lesser percentage of the money. If they have to sell the house in the future, extracting 75% of its value will be easier than extracting, let’s say, 85%. So, the risk is low and any lender should readily offer you a loan at attractive prices.
At LVRs higher than 80%, the risk for the lender increases. As mentioned before, the costs of the mortgage may increase. But, why? To mitigate their risk, the lender will need the buyers to get a Lender’s Mortgage Insurance (LMI). LMI will provide the extra protection to the lender to cover their losses if the sale of the property cannot get their money back. But, understand this – LMI is meant to cover the interests of the lender, while you end up paying for it. You, as a borrower, will not receive any kind of coverage from the LMI product. As the LVR goes up, so does the LMI. Hence, the cost of the overall loan also becomes higher.
You can bring these costs down and get a loan even with a 100% LVR, if you can get a guarantor to sign your application. Usually it is a family member, but it can be anybody with an equity stake in some other property. Basically, by playing guarantor, they are putting up a piece of the property they own as a security against your loan.
You can release the guarantor from this responsibility in two ways, by increasing the size of your repayments and paying off the guarantor a portion of the loan faster. Also, if the price of your property appreciates considerably then the guarantor can be freed up from your loan. Since the property value has gone up, the LVR has come down and the lender does not need a guarantor to vouch for you anymore.
How does a lender value a property?
A lender will not always carry out an independent valuation of the property for which you want to take a loan. They will just refer to the purchase price on the sale deed as the value of the house. This only happens when your particular case fulfils some of their criteria. The criteria usually include an LVR lower than 80%, a loan amount below $800,000, licensed agent brokering the sale, complete income records from the borrower, and more.
LVR is a lender’s method of quickly eliminating the loan applicants who are too high risk for them. Alternatively, for the borrowers like you, a high LVR is an indication that the loan costs are going to be high. Hence, it is best to either muster some more funds or to apply for a home loan at a later time, when they can get a better deal.