One of the major considerations that mortgage lenders have when evaluating loan applications is assessing the level of risk that is involved in approving a loan. Lenders must take into account the probability of default and have a way of predicting risk in order to make wise lending decisions.
One of the major financial indicators that lenders use in assessing risk is the loan to value ratio. This financial ratio is a measurement of the proportion of loan amount to the recent sales price or appraised value of the property. This financial ratio is derived by dividing the amount of the loan by the property’s value. If the loan is for $80,000 and the property value is $100,000, the loan to value ratio is 80%. The lower the loan to value ratio is, the more risk there is for the lender.
Another financial ratio used to evaluate risk is the combined loan to value ratio (CLTV). This financial ratio measures the proportion of all the loans associated with the property versus the property’s value. This ratio is useful if there is more than one loan (or lien) on the property. There could be a home improvement loan or second mortgage in addition to the original mortgage. To find the combined loan to value ratio, the amounts of all the loans are added together and then divided by the property’s value.
A higher down payment or larger equity in the property will result in a higher loan to value ratio and lower risk for the lender. Mortgages with down payments of less than 20% will usually require the borrower to carry private mortgage insurance because of the higher risk.
Low loan to value ratio loans will require a better credit rating and have higher interest rates than high loan to value ratios. Larger down payments will be required from higher risk borrowers.
When applying for a mortgage it is critical to understand how lenders evaluate and measure their risk in approving your loan. The larger your down payment, the less risk the lender has to take. In case of default, there will be more equity in the property than there would be on a loan with a low down payment. In the event of a default on the property, the equity will help to offset any potential loss the lender may incur. Therefore, the loan to value ratio plays an important role in the lender assessing their risk and approving your loan.