What exactly does LVR mean and how do lenders use it to determine the risk factor of your home loan? Find out this and more.
LVR stands for Loan to Value Ratio and is the amount of money you borrow for a home loan compared to the value of the property and expressed as a percentage. Lenders use this calculation to determine the risk factor of the home loan.
For example a 50% LVR means that the amount you owe is half of what the property is worth. From a lenders perspective this is low risk because if you default on your loan, the sale of the property should more than cover what you owe.
On the other hand a 90% LVR is a lot tighter and thus higher risk. This is where the amount you owe is 90% of the value of the property. This definitely represents a higher risk for the lender, which is why they take out an insurance to protect themselves in case you default called Lenders Mortgage Insurance or LMI.
What is considered high risk?
Home loans with an LVR of more than 80% are considered riskier. Most lenders will lend up to 95% of the value of the property, but the higher the LVR, the riskier the loan. This could mean lenders implement a higher interest rate or take out insurance to reward and protect themselves for taking the risk.
To calculate the LVR, simply take the loan amount and divide it by the property value or purchase price.
If you are purchasing a property that costs $400,000 and have a deposit of $80,000, this means you will need to borrow $320,000.
$320,000 ÷ $400,000 = 0.8
0.8 x 100 = 80
This means your LVR is 80%.
As mentioned above, the higher the LVR, the ‘riskier’ the home loan. Once the LVR goes above 80%, lenders will usually start to implement certain restrictions. Some of the challenges involved with a high LVR loan are:
- Application is heavily scrutinised
If you are considered a high risk borrower, lenders are going to be more cautious. This means that they will look at your financial situation very carefully. Even if you don’t have defaults they will look carefully at things like your savings pattern, the stability of your employment and your level of personal debt like credit cards and personal loans. If these cause them concern you may need to shop around for a lender who is willing to take on more risk and settle for a loan with a higher interest rate or put off purchasing until you have saved a larger deposit.
- Higher interest rates
Many lenders have tiered interest rates which means that for the same loan product, different interest rates will apply according to the LVR. Typically the cheapest interest rate will be for loans up to 80% LVR, a higher rate for loans from above 80% to 90% LVR and the highest rates for loans above 90%. This is a reflection of the risk level of different LVR’s.
- Lenders Mortgage Insurance
If your LVR is above 80%, lenders may pass on the cost of Lenders Mortgage Insurance (LMI). LMI insurance that the lender takes out to protect themselves if you default and are unable to meet repayments. The cost is a one-off premium that is usually passed onto the borrower and can amount to thousands of dollars. The higher the LVR the more expensive the insurance premium.
- Higher loan amount
If LMI is added to your loan, then this increases the loan amount. This eats into the amount of equity you have, so a 10% deposit or 10% equity may be reduced to 8 or 7% if mortgage insurance is added. This means it will take even longer to reach the magic 80% LVR when LMI won’t apply.
- Refinancing can be costly
While ever your loan continues to be above 80% of the value of the property, if you want to refinance to a loan to a cheaper interest rate and lower fees, the cost of LMI might not make it worthwhile. As LMI is lender specific it can’t be transferred. So after already paying for it once, if you refinance you may have to pay it again. This may mean that the cost may outweigh the benefits of the lower interest rate and result in you being locked in with your current lender until the LVR reduces.
- Reduce choice of locations
Lenders categorise where the property is situated into low, medium and higher risk locations. If you are looking at purchasing a property in a regional location, lenders may reduce the amount that they will lend and have a maximum LVR that is lower than 95%. This may mean that you have to save a larger deposit, buy in a location that is considered less risky or find a lender who will lend you what you need for that property. If you choose the latter option, it could mean that you may have to settle for a loan with a higher interest rate and fees.
To find out more about the impact that the location of the property has on lending and what you can do about it, click here.
Having a lower LVR has lots of benefits as can be seen above. Not the least of these is having the option to refinance your loan if you want to a loan with a cheaper interest rate and superior features.
Using a Guarantor
A guarantor can help reduce the LVR so that the borrower can avoid the cost of LMI and possibly secure a lower interest rate. How this works is the guarantor allows the lender to use a property they own as an additional security for the loan. So the lender has the title to the property the borrower is purchasing as well as the property that the guarantor is allowing to be used. The borrower may be able to borrow up to 100% of the purchase price plus costs like stamp duty using a security guarantee. There are a number of risks involved with being a guarantor so understanding these and seeking the relevant advice is essential.
Find out more about being a home loan guarantor.
Increasing the equity
Reducing the LVR is also all about increasing your equity. Ideally you will want to pay your home loan off before you retire so looking at ways to bring down the LVR from day one is really important.
The LVR can be reduced by either:-
Increasing the value of the property
The value of the properties tend to increase steadily with the market, but depending on where the property is located and the property cycle, this may be happen quickly, slowly, stagnate or even decrease. So relying on the market to create your equity can be fraught with danger. The alternative is to create your own value. This can be done by making improvements to the property that increase the value of the property.
Increases in the market value
If you have purchased a property in a growth area, the value of the property should increase steadily. This may not always be the case which is why doing thorough research is essential when you purchase. Some investors can often look for properties that are undervalued and so have made a gain already at the time they purchase.
Read our blog on what signs to look for to find an undervalued area.
- Creating your own value
Renovations and improvements can help increase the value of the property. Care needs to be taken to ensure that whatever you do increases the value by more than what you spend often, referred to as over capitalising. This means that you need to do thorough research before you start planning and be mindful of over capitalising.
Reducing how much you owe
- Pay or save more
There are a number of ways to do this but the easiest is to focus on paying off your home loan quicker. Don’t just settle for minimum repayments. Set yourself a target of paying your home loan off in a shorter term than what you originally took out. Consistently paying extra from the start of the loan will accelerate paying off your loan.
Careful budgeting, looking for a higher paying job, taking on a second job or selling household items that you no longer need, can all increase your available cash that you can put towards your home loan or help boost your savings if you are looking to purchase.
- Refinance to a cheaper interest rate
Ensuring that your loan interest rate is still competitive and having access to interest saving features, can also speed up reducing what you owe. The less you pay in interest means that the more of your repayment can go towards reducing what you owe and in turn lower your LVR.
If you cannot afford to make extra repayments because you are living in your dream home then maybe it is time to consider downsizing. Buying a property that is not worth as much, could mean that you can significantly reduce your loan size and LVR. This can sometimes be an option when approaching retirement so that you can retire debt free.
Put your loan details into a loan repayments calculator. Use the slider to gradually reduce the term to see what the repayments would be to pay it off 5 or even 10 years faster. You might be surprised at what a difference it makes. Set a goal for paying off your home loan off over the reduced term and use this as motivation.
Try it out yourself with out Loan Repayments calculator.
Although there are a number of challenges and restrictions involved with a higher LVR, is there ever a time where it could be beneficial? The answer is yes.
If one of your goals is to get into the property market as soon as possible, you may consider using a higher LVR home loan. Getting into the market now means you can start repaying the home loan straight away and start to build equity.
Did You Know?
According to the Genworth Streets Ahead Report, first home buyers face particular difficulty in saving a deposit, with the proportion of first-time buyers who tipped saving a deposit as the biggest barrier to ownership increasing by 82% over the past 12 months.
Saving a home loan deposit can take a number of years, which means you may miss out on your ideal property in a suburb that is set to boom while you are trying to save. Also, if interest rates are low at the moment and are expected to rise within the next few years, it could be beneficial to lock in a lower rate now.
But remember, all of the challenges listed above need to be taken into consideration. Will you be able to afford the higher repayments if interest rates do rise?
Maddie is a final year university student working part time and has been house hunting for the past 12 months. She is looking for a property around $400,000 and has been saving for a home loan deposit for the last 4 years while living at home with her parents.
At the moment she has saved $40,000, which gives her an LVR of 90%. Her parents have generously given her a gift to cover the stamp duty and costs.
Maddie has found an ideal property in her price range in a developing suburb and decides to purchase it despite the fact that she will be faced with a higher interest rate and have to pay LMI.
Maddie buys the property and in the first year it increases in value by 10%. By continuing to live at home and renting the property out, she is able to accelerate her repayments and is looking to reduce the LVR to 80% in a few years.
LVR plays an important role in lending, so the more you know and understand about how it is calculated and what it means, the better prepared you are to chat to lenders about home loans.
If you need help calculating the loan amount, LVR or need to know what loan you qualify for, our lending specialists can helpJust call 13 72 62 or leave your details here and they will contact you.