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Understanding loan to value (LTV) and why it matters

Understanding loan to value (LTV) and why it matters
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If you are thinking about getting a mortgage, you might have heard about loan to value (LTV). If you are unsure about what it is and why it matters, we’re here to help.

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What is loan to value?

It is a ratio usually expressed as a percentage. It’s used to illustrate the size of a mortgage relative to the value of the property.

So, imagine you are going to buy a house that is worth £250,000 and you have applied for a mortgage for £200,000. The loan to value in this situation is 80%. Your deposit will be £50,000.

The loan to value is therefore also a measure of the size of your deposit. The greater the loan to value, the smaller the deposit.

How is it used?

When lenders advertise their products, they typically quote a maximum loan to value for each mortgage.

For a given product, this is the maximum amount they will lend to you expressed as a proportion of the value of the property.

So, imagine you apply for a product with a maximum LTV of 75% to buy a house worth £250,000. The maximum amount the mortgage provider will lend you is 75% of £250,000, or £187,500. You will therefore need a deposit of £62,500.

Lenders use the LTV to offer a range of products with different interest rates. Mortgages with lower maximum LTVs have lower interest rates.

This is because from the lender’s point of view, homebuyers that have larger deposits are considered to be low risk.

What is the disadvantage of a high LTV mortgage?

There is a greater risk of negative equity for homebuyers with high LTV mortgages.

Take our original example of a house worth £250,000. Imagine now having a mortgage worth £225,000. The loan to value is now 90%.

If the value of the property falls to £200,000, the homeowner is in a situation where they are paying off a mortgage which is more than the value of the property. In other words, the homeowner is in negative equity.

In the past, many borrowers purchased properties using very high LTV mortgages on the basis that the value of their property would increase.

However, house prices rise and fall in response to market conditions. During an economic downturn, property prices fall, and the potential for negative equity increases.

Many borrowers were caught out because they purchased expensive properties and did not make allowances for the fluctuation in house prices.

Why is negative equity a problem?

As such, negative equity is not too much of an issue if you can afford your mortgage payments and you are happy with your living situation.

While it is not guaranteed, past performance shows that property eventually does go up in value. But, you may need to be prepared for a long-term commitment.

However, periods of economic depression can often result in job losses and financial insecurity. You could end up in a situation where you are struggling to pay your mortgage.

If you are in negative equity and you are forced to sell your home, you will end up owing money to the lender.

How can I avoid negative equity?

Reducing your loan to value as much as possible from the outset is key.

At the moment, an LTV of 75% or less will give you access to a wide range of mortgage deals with reasonable interest rates.

Increased equity in your home will prevent potential problems associated with negative equity. So, if the worst happens and you are forced to sell your home, you won’t end up out of pocket.

How can I reduce the LTV?

There are two basic ways you can do this.

The first is by increasing the size of your deposit. This may mean delaying the purchase of a property while you save more money.

The second is to look for a cheaper property. This could involve looking in a different area, or considering properties that need some renovation.

Finally

When applying for a mortgage, it’s important to be realistic about the size of mortgage you can afford.

LTV is a good indicator of affordability, so aiming for a low LTV will prevent you from overextending yourself financially.

If you are applying for a mortgage, further information is available from the Money Advice Service.

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