Conquering The Terms Of Your Mortgage

If you've ever shopped for a mortgage, you've probably run afoul of three dreaded little letters: LTV. These letters stand for the loan-to-value ratio, and it's this ratio (along with a few other numbers) that controls the terms of your mortgage.

It's a surprisingly simple calculation:

Basically, the ratio tells the mortgage lender how much money the lender will be fronting versus how much you will be putting up with your down payment. Logic would seem to dictate that those buyers putting up big down payments or those who have a lot of money invested in the home will get the best terms because they present the least risk to the lender - but life is never that simple, is it? This article will take you through the ins and outs of the LTV calculation and how it is used.

LTV Basics
The loan-to-value metric is derived by dividing the borrower's total mortgage proceeds by the appraised value of the property being financed. When financing a new home purchase, the negotiated purchase price is used for the property value, while in a refinancing situation the property valued is derived by a third-party appraisal conducted by one licensed to do so. Since the property represents the lender's collateral, this simple metric represents the percentage of the property that the lender is actually financing.

Most residential mortgage loans are provided to borrowers with LTVs of 75-100%, in which the borrower is putting down or has equity in the property of 0-25%. In general, any loan that is above 80% is considered a high LTV loan. Since it's rare that someone can afford to pay more than a 20% down payment on a new house, this includes most residential mortgages.

When mortgages default and properties are foreclosed upon, the lender sells the property, usually at a discount to value, to ensure a quick sale. The lender is then allowed to keep all proceeds up to the mortgage balance outstanding. In the case of high LTV loans, this often results in financial losses for the lender. In the rare case that a low LTV loan defaults, lenders have a high probability of recovering their capital even when the property is sold at a discount. All other variables being equal, low LTV loans have a lower rate of default because the carrying costs, monthly interest and principal payments, mortgage insurance, etc., are based on a smaller mortgage balance as compared to high LTV loans.

How Lenders Use LTV
LTV is one of the measures that lenders use to help assess the risk associated with real estate lending and then determine the terms of the mortgage. This is called risk-based mortgage pricing. Another metric used is the debt service coverage ratio (DSCR); it is calculated by dividing the monthly loan costs by the borrower's monthly net income available to pay the monthly debt service.

These two metrics - along with a borrower's credit profile - comprise the information that has the greatest effect on loan terms and the cost of borrowing. (To learn more about these calculations, read Make A Risk-Based Mortgage Decision and Mortgages: How Much Can You Afford?)

The aftereffects of the subprime crisis of 2007 led to considerably more conservative underwriting standards and a general flight to quality by real estate lending institutions. This change has resulted in greater bargaining power for borrowers seeking lower risk, higher quality loans.

New Options for Low LTV Borrowers
To understand the pricing of your mortgage, it's important to first understand that the company that initially lends you the money, called the mortgage originator, very rarely holds onto your mortgage. There is a vast underworld called the secondary mortgage market, where mortgages are sliced, diced, grouped and packaged for resale as mortgage-backed securities (MBS). These securities are pools of mortgages and their cash flows, usually all with similar terms. (For a detailed examination of the secondary market, read Behind The Scenes Of Your Mortgage.)

Historically, a borrower's ability to pay the mortgage and his or her credit rating dictated the terms offered by lenders. The higher these metrics were, the lower the probability that the loan would go into default, and the better the terms the borrower received. Then along came the murky world of mortgage-backed securities and logic got thrown out the window. MBS investors required that a majority of loans in a specific pool have similar financial terms, because investors of real estate financing instruments prefer collections of assets with similar financial terms, such as yields and investment horizon.

Traditionally, low-LTV loans comprise a small percentage of the overall market for mortgage capital. The reason for the small number of low-LTV loans is that most of them are requested by borrowers wishing to roll over the entire amount of equity from a previous property sale, or by those who wish to refinance a loan that has been significantly paid down. Basically, there just aren't that many people who are able to make an 80% down payment.

The small number of low-LTV loans made it difficult to bundle them together and sell them as an MBSs. There was little demand from the secondary market, and so there was also little incentive for the originators to seek out low-LTV borrowers by giving them great terms. Lenders would originate the loans, but they may have been reluctant to offer rate discounts or payment flexibility to offset the reduction in default risk. (To learn how investment in this MBS field works, read Profit From Mortgage Debt With MBS.)

Subprime Changes the Rules
Low-LTV loans were out of style but the MBS market was soaring. Demand for MBS products skyrocketed before the housing bubble burst in 2007. Sometimes it seemed like the riskier the loan was, the more the market loved it. All sorts of new subprime mortgage species evolved, each requiring less money from the borrowers, as long as they'd just sign on the dotted line. No income, no job and no assets? No problem. The NINJA loan came to the rescue. As long as the housing market stayed hot, the whole machine could keep rolling. But of course, the housing market didn't stay hot. (To learn more, read The Fuel That Fed The Subprime Meltdown and Why Housing Market Bubbles Pop.)

When the housing market imploded, default rates rose. Loose lending standards were seen as a primary culprit, and, as a result, many conduit lenders (lenders that originate loans that are pooled for securitization) increased their underwriting standards, requiring greater amounts of equity or income from borrowers, or suspending their higher yielding activities until the financial markets stabilize. This has allowed portfolio lenders (lenders that originate loans to be held privately by their investors often through maturity), and other mortgage originators that typically lend at lower LTV rates to supply a greater portion of mortgage capital. (For related reading on the lending standards debate, see Subprime Lending: Helping Hand Or Underhanded?)

Due to a decrease in MBS issuance and the ability of other institutions, such as portfolio lenders, to compete successfully with conduit lenders, low-LTV loans are getting greater acceptance with investors wishing to reduce the overall risk of their mortgage portfolios. This brings us back to the important point for low LTV borrowers. There is greater demand for their loans, and they can now dictate terms in some situations.

Borrowers must realize that LTV is not the only metric that is important in getting one's loan closed. Lenders and mortgage investors are in the business of receiving income from lending capital and not from owning real estate. That is to say, no matter how little the loan balance is as a percentage of the property value, a lender does not want to have to foreclose and sell your property to get the capital back. Borrowers who do not have the requisite credit rating or ability to generate enough income to offset mortgage liabilities will still find it hard to dictate terms or reductions in loan costs.

The loan-to-value ratio is a snapshot of how much risk the lender is taking on. This metric used to work against those seeking low-LTV loans because there was very little demand for these loans. Borrowers were almost punished for having too much of their own money invested in the property. The subprime meltdown has corrected some of this imbalance. With the financing markets focused on a flight to quality and managing default risks, borrowers of low-LTV loans can be selective and will find lenders receptive to financing their low LTV properties. Real estate owners will find themselves competing in a borrower's market, at least until the next bubble begins to grow.