You may have heard the term loan to value ratio (LVR) used in the mortgage industry. However, many people don’t understand what this means or how it affects them.
The LVR attached to your home loan is a proportional number that measures the amount of money you borrow against the actual value of the home.
Lenders use LVR to figure out how much risk comes with the loan. Thus, it is a key metric when it comes to the lender’s decision on whether to approve your home loan application.
As a general rule, the higher your LVR, the more risk you present to a lender.
Your lender will examine the property’s value while taking your deposit into consideration. The lender divides your home’s value against the deposit to figure out how much you need to borrow.
Let’s look at a couple of examples involving a $500,000 property and two different deposits.
Our first example assumes you have raised a deposit of $125,000, meaning you need to borrow $375,000. Your lender uses the following calculation to figure out your LVR:
500,000 – 125,000 = 375,000
(375,000 / 500,000) x 100 = 75
LVR = 75%
This is an attractive LVR as it presents less risk to the lender. It shows you have saved well to contribute a high deposit, thus the lender can trust you to continue that level of financial commitment.
Now, let’s halve the deposit to $62,500. The sum then becomes:
500,000 – 62,500 = 437,500
(437,500 / 500,000) x 100 = 87.5
LVR = 87.5%
This is a much higher LVR, which shows that you represent more risk to the lender.
Ideally, your home loan should carry an LVR of 80% or below if you want to stand the highest chance of getting approval. Any loan with an LVR exceeding 80% usually carries extra fees, the most common of which is Lender’s Mortgage Insurance (LMI). Lenders use LMI to protect themselves against you defaulting on the home loan.
Beyond the extra fees, you will face other issues when you have a high LVR. For one, you will have to deal with higher monthly repayments because of your lower deposit.
While this may not present an issue immediately, these higher repayments could cause problems if you run into financial trouble later on. Waiting until you save a larger deposit may save you a lot of hassle in the long run.
Spending extra time saving a deposit isn’t always an option. That’s where having a guarantor could help you. A guarantor is usually a parent or family member who uses the equity in their own home to provide a security for your home loan.
This allows you to take out a home loan without saving a deposit, but there are some risks attached. If you default on the loan, you cause problems for your guarantor. They will have to pay what you can’t, or risk getting a black mark on their credit report.