If you're thinking of buying a house and applying for a mortgage, you'll need to know all about loan-to-value. Here's our guide covering what you need to know.
If you’re considering buying a house and applying for a mortgage you’ll very quickly get used to people talking about loan-to-value, or LTV for short. But what does it mean?
Quite simply, loan-to-value is a way of expressing the difference between the value of the house you’re buying and the amount of money you’re borrowing to pay for it. It is one of the main factors that your bank or building society will assess when deciding whether you qualify for a mortgage.
So how does it work?
The average value of a home in England is now upwards of £270,000, meaning most people will have to borrow hundreds of thousands of pounds in order to buy their own home.
While this might seem like a daunting prospect, the mortgage industry is regulated to ensure that you can safely borrow the money, and pay it back in manageable monthly installments over a set period of time. No bank or building society will lend you money if they have reason to suspect you might struggle to pay it back, and loan-to-value is one of the most important ways in which they judge this.
Loan-to-value describes the way in which the amount of money you’ve borrowed relates to the value of your house. Usually, a loan-to-value calculator will express it as a percentage.
For example, if you are looking to buy a house valued at £250,000, and have saved up a deposit of £50,000, you will need a mortgage of £200,000.
£200,000 (mortgage) ÷ £250,000 (whole value) = 0.8
0.8 x 100 = 80 (80 per cent)
Your loan-to-value would be 80 per cent, meaning that the money you're borrowing adds up to 80 per cent of the value of the property, and you own 20 per cent of it outright.
The £50,000 deposit (available upfront as cash) is described as ‘equity’. As a homeowner gradually pays backs the money borrowed, the equity will increase.
For example, if, after five years, you have managed to pay back £50,000 of the loan, your equity will increase to £100,000 (£50,000 deposit + £50,000 paid back).
100,000 (new equity value) ÷ 250,000 (whole property value) = 0.4
0.4 x 100 = 40 (40 per cent)
You now own 40 per cent of the value of your home, and your loan-to-value will decrease to 60 per cent, the remaining value.
Loan-to-value calculation as house prices change
This is where it gets slightly more complicated. Although you’ll be making your monthly payments at the rate you agreed when you took out the mortgage, the value of your house is unlikely to stay the same. Home buyers must be aware that house values can fall as well as rise.
Increasing house prices
The average price of a home in Britain has risen in recent years. It means a £250,000 house that you bought several years ago could now be worth £350,000, or even more.
It means that your 40 per cent equity (the proportion of the house you own outright) is now worth £140,000, rather than the £100,000 you’ve actually paid towards the mortgage. Congratulations, you’re richer by £40,000.
And what does this do to your loan-to-value? Since you still owe the bank £150,000 of the £200,000 you originally borrowed, but the house is now worth £350,000, your loan- to- value is reduced to 43 per cent - a great improvement on the 80 per cent you started out with five years ago.
Falling house prices
However, house prices can go down as well as up. During the credit crisis many people lost a lot of money - and even their homes - after taking out high loan-to-value mortgages on the assumption that property prices would continue to rise. The same problems were faced by those who took out interest-only mortgages because they were only paying off the interest and not the loan. It meant they built up no equity and so lost out when prices crashed.
If things don’t work out quite as you’d hoped, and after five years your home’s value has fallen to £200,000, you will need to recalculate your loan-to-value. If you’ve kept up with your monthly payments then you’ll still have paid off £100,000, the equivalent of half the value of your house. But the problem is that you still have £150,000 outstanding on your mortgage while your house is now only worth £200,000. It means your loan-to-value is 75 per cent - only a small amount lower than it was when you started.
Things could get worse though. Consider a family who bought their house for £500,000 with a £50,000 deposit, taking out a mortgage of £450,000, which is 90 per cent loan-to-value. They’ve managed to pay off another £50,000, reducing their overall debt to £400,000. The problem is that their house is now only worth £350,000. This is what is known as negative equity – owing more on your mortgage than your property is worth.
This was the scenario during the 2008 credit crisis, when Halifax - then Britain’s biggest mortgage lender - reported that in the 12 months to the end of September of that year, house prices fell at a record 13.3 per cent.
The family now has a problem on its hands. If they decide to sell their house, they won’t be able to get more than £350,000 for it. But they will still have a debt of £400,000.
Negative makes it almost impossible for the family to remortgage. If, for example, they wanted to change to a new mortgage lender that offered a more favourable interest rate, they would probably be turned down. Since the 2008 credit crisis, mortgage providers are no longer willing to lend more than the actual value of the property. It means the family may end up automatically slipping onto an expensive standard variable rate mortgage at the end of their initial deal - something that does not protect them against further interest rate rises.
Why is LTV important?
Loan-to-value is one of the most central factors in deciding not only whether you can get a mortgage, but what type of mortgage you are able to take out. Lending people large amounts of money can be a risky business, and mortgage lenders are understandably careful about who they offer loans to. As well as looking closely at your income, liabilities and other assets, they will take into account the potential loan-to-value of the property you are proposing to buy. And as you would expect, the higher the ratio of the loan-to-value, the more risky it is for the lender. So your £250,000 house, purchased with a loan-to-value of 80 per cent, was a more attractive deal for a lender than the family’s Robinsons’ £500,000 house, purchased with an loan-to-value of 90 per cent.
Mortgage providers will usually try to reduce this risk by charging a higher rate of interest for mortgages with a higher loan-to-value. Although this helps to protect the lenders, it can sometimes cause problems for the borrowers as, since higher interest repayments can be more difficult to meet, and may increase your risk of defaulting on the loan.
The Government’s Help To Buy scheme has made it possible for first-time buyers and those already on the property ladder to get a mortgage with as little as a 5 per cent deposit. To reduce the risk to mortgage providers in offering a loan against such a low level of equity, the Government offers lenders the option to purchase a guarantee on mortgage loans. This is offered under the Help to Buy mortgage guarantee. With this support, lenders are able to offer home buyers mortgage agreements with a loan-to-value of up to 95 per cent.
Loan-to-value is of particular concern to first-time buyers, who might have been saving for years for a deposit. They will usually have to opt for a higher loan-to-value, with the hope of reducing it in a few years, and potentially remortgaging at a lower rate somewhere down the line.
Although it may be tempting to step onto the property ladder as soon as you have the minimum amount required for a deposit, it is worth considering whether this makes the most sense financially. The larger a deposit you are able to save, the lower the loan-to-value you’ll have. It means you will get a better mortgage deal and pay less in interest over the full term of the mortgage.
You will also find, as you go through the process of entering into a mortgage agreement, that there are significant extra costs, including legal fees and potentially stamp duty. Once these are taken into account, you may end up having less of a deposit than you were expecting, and you may need to borrow at a higher loan-to-value.
Remortgaging or moving house
Loan-to-value is just as important a consideration for people moving house, or remortgaging an existing property. The amount of equity you hold in your property will affect your ability to remortgage, and may limit your options if you decide to move house.
If you have been paying off your original mortgage for several years, and house prices have gone up or remained stable, you will hold a greater amount of equity. It means you will be are able to take out a new mortgage with a more favourable loan-to-value ratio, and possibly much lower interest rates than you did before.
However, if house prices are currently going through a low point, and there is no urgent need to move, it may make sense for you to stay where you are for a couple of years. If the value of your house goes up again, your loan-to-value will go down, which means you stand a better chance of getting a good deal if you remortgage, and saving yourself money.
Equity release schemes
At the other end of the scale are homeowners considering equity release, where money is borrowed against the value of an existing property to see them through their later years. Just like any other mortgage, the terms of an equity release loan are dependent on your loan-to-value ratio. If you take out one of the most popular types of equity release scheme, known as a lifetime product, the interest will be added to the loan over time and only paid off when your property is eventually sold, either on your death or when you decide to move into full-time care.
Equity release is only offered for relatively low loan-to-value ratios – there are few schemes that accept a loan-to-value of more than 50 per cent and most state their maximum as somewhere between 40 per cent and 45 per cent. For this reason, you will only normally be eligible for an equity release scheme if you have paid off your original mortgage, or if you only have a small percentage of it remaining.
Taking out a mortgage – or remortgaging an existing property – can often be a daunting and confusing process, with all too many acronyms and facts and figures to get your head round. Loan-to-value is one of the most important of these. It is also a helpful way of understanding the actual value of a property, working out whether you can afford to buy it, and what sort of mortgage and interest rates might be available to you.
How to work out loan-to-value
As we’ve discovered, your loan-to-value won’t stay the same for long. Since house prices can fluctuate, your loan-to-value could easily go up or down, even if you are only paying the interest on your mortgage, without making any difference to the debt itself.
Loan-to-value will also change throughout the lifetime of your mortgage, usually decreasing slightly with every repayment you make. As you progress through the course of your mortgage term, and your loan-to-value evolves, so will the opportunities available to you. You may find that you are able to renegotiate your mortgage in order to pay it off more quickly, or to get a more favourable interest rate.
Even if you have been paying off your mortgage for several years, it is in the interests of your general financial health to regularly check your loan-to-value. You might be eligible for a better mortgage deal and save some money in the process.
Most banks and building societies classify mortgages into different loan-to-value bands. If you’re towards the bottom of the scale for loan-to-value, you’ll qualify for their lowest rate of interest. If you’re near the top end of the scale, your interest level will be higher. Generally speaking, borrowers with a loan-to-value of 90 per cent will be charged the most, while borrowers with a loan-to-value of 75 per cent will be charged less. Borrowers with a loan-to-value of 60 per cent or lower will be offered the most preferential rates.
For example, a borrower with a loan-to-value of 60 per cent may be able to obtain a interest rate of around 1.5 per cent. But someone with a loan-to-value of between 60 per cent and 75 per cent, will probably only be offered higher rates of around 2 per cent. Those with an even higher loan-to-value, can expect to pay more.
Reminder: how to work out your loan to value
As shown above, simply divide the amount you are looking to borrow (or the balance of your existing mortgage) by the total value of the property, then multiply it by 100. This will give you your loan to value percentage.
Another quick calculation example:
A buyer wants to buy a property worth £200,000 and has saved up a deposit of £50,000. They need to borrow £150,000.
£150,000 ÷ £200,000 = 0.75
0.75 x 100 = 75
Their loan-to-value is therefore 75 per cent.
How to influence your loan-to-value ratio
Your loan-to-value can make a big difference to how much you are allowed to borrow, what your interest rate will be, and ultimately how much your property will cost you during the course of your repayment period. It makes sense to do everything in your power to reduce it as much as possible.
The loan-to-value bands outlined by various banks and building societies can be a good guideline. If you are saving up for a deposit and currently have slightly less than you would need to reach a particular loan-to-value threshold, it may well be worth hanging on for a few months longer. Increasing the size of your deposit - (and thus, reducing your loan-to-value) - may mean you then qualify for the best value loan, which will save you thousands of pounds in the long run.
An alternative, if you have found the perfect property and are unwilling to wait, is to negotiate with the seller to bring the price down. Even a comparatively small reduction might send you into a more favourable loan-to-value band, which will not only save you money, but also improve your chances of being accepted for a mortgage.
Add property value
If you are remortgaging or moving house, you can take the opportunity to reduce your loan-to-value by repaying an extra slice of capital, or finding a way of adding value to your property, in order to be eligible for the best value loan. Converting a loft, putting in a new kitchen or landscaping a garden will cost you a few thousand pounds, and will require a survey. But ultimately, it could increase the value of your house by much more, and could in turn send you into a different loan-to-value band. This will reduce the interest you have to pay on your new mortgage.
It is also a good idea to shop around, as some mortgage providers will only offer substantially higher rates to those borrowers with a higher loan-to-value. And don’t forget that buying a house comes with a lot of extra costs that could eat up more of your savings than you were expecting. As well as legal fees and potentially stamp duty, it is a good idea to put aside some money for unforeseen expenses that might arise during the moving in period. Once you have subtracted these costs, your deposit fund might be significantly smaller, and you may find you do not qualify for the loan-to-value threshold you had been hoping for.
Mortgages to match loan-to-value
As with all big financial decisions, it pays to shop around, as mortgage providers can vary considerably in the deals they offer, especially between different loan-to-value bands. Once you have saved up your deposit, found the property you wish to buy, and worked out your loan-to-value, you will then need to look at the terms, fees and interest rates of all the different mortgages that are available to you.
As an example, one of the best mortgage rates at the 60 per cent threshold is currently offered by HSBC, which offers an two-year initial interest rate of 0.98 per cent, followed by a subsequent rate of 5.45 per cent once the initial deal comes to an end.
If your loan to value falls below 75 per cent, the best rate is offered by the Post Office. It, who offers a two-year fixed interest rate of 1.19 per cent%, which subsequently increases to 4.49 per cent%.
Although you may be wary of spending yet more of your hard-earned cash, it can often pay to use the services of a mortgage broker. They are a qualified professional who has arranged hundreds of other mortgages, understands the industry, and knows what’s currently on offer.
Using a broker will not necessarily cost you more money. Whatever fee they might charge is often much less than the savings they help you make. Some have access to “broker exclusive” deals that are better value than those available direct from a mortgage provider. Some brokers don’t actually charge the borrower anything, and instead make their money by taking a commission from the lender. A broker will also be able to advise you on the type of mortgage to take out, and on effective ways to maximise your assets, and save yourself the most money.
It’s often said that buying a house is one of the most stressful experiences in life. Zoopla believes that it doesn’t have to be. We hope that this guide will have helped you to understand the importance of loan to value, and given you an idea of how to improve yours. If you need more information on the right mortgage for you, you can access our Zoopla finance centre.