Do you have a mortgage? Do you know what your loan-to-value ratio is – and what interest rate band that puts you into with your bank?
Oh, I see… You have other hobbies.
Look, I appreciate there’s nothing more boring than a mortgage deal. Especially when half of you already know what I’m talking about, and will nod off in about 150 words’ time.
But if you don’t, please keep reading. You might save yourself a lot of money.
Just ask Richard, a first-time buyer.
Richard was stretching to buy his first flat. And because I’m the sort of person who has blogged about money for 17 years, I asked him what his loan-to-value was.
“Huh?” said he.
Long story short: by releasing an extra £2,000 from an ISA he’d mentally segregated for something else, Richard could reduce his total mortgage repayments over the next five years by over £8,000.
That’s a 300% return on the extra £2,000 he put down!
What is the loan-to-value ratio for a mortgage?
I’ll say upfront: this is a particularly extreme example. Richard is arty, clueless with money, and rarely reads a menu let alone the financial small print.
What’s more Richard was set to borrow at his bank’s steepest rate for first-time buyers, before he found that extra money down the back of the metaphorical sofa. The savings will rarely be so big.
Nevertheless the principle holds for all mortgages.
And personally I’d rather have any extra money, however tiny, if the alternative is it goes to a bank.
So what’s going on here?
Well, it starts with the loan-to-value (LTV) ratio of your mortgage.
The LTV ratio is simply the ratio of what you’re borrowing from the bank – the mortgage – compared to the purchase price of the property.
For instance, say you’re buying a home that costs £400,000 and you’ve got a £100,000 deposit. You’ll need a £300,000 mortgage to complete the purchase.
- That is a LTV ratio of £300,000/£400,000, which works out at 75%.
Or say you have a mortgage of £270,000 on a £336,000 property.
- The LTV ratio is £270,000/£336,000 = 80.35%
As we’ll see in a moment, those pedantic two decimal places are the whole point of this article.
But first a quick detour into why banks care about LTV ratios.
Loan-to-value ratio and riskiness
Although it remains hard for those of us who lived through the financial crisis to believe it, banks are in the business of managing risk and return.
And mortgages are the least risky debt – for both banks and borrowers.
That’s because mortgages are secured loans.
The property being bought is put up as collateral by the borrower. If you don’t meet your mortgage payments, then your bank can seize and sell your property to cover the mortgage and recoup what it lent you.
This clearly makes a mortgage a safer form of debt for the bank, because it is asset-backed.
But it’s also safer for you as a borrower. The rate charged on an asset-backed mortgage will be much lower than that on a credit card or a personal loan.
Less risky does not mean risk-free. A mortgage is still a big liability, and you can lose a lot of money if things go against you. All debt has downsides.
Of course, banks aren’t desperate to seize and sell their customers’ assets to get their money back. Partly because it makes for bad publicity, particularly when they’re all at it. But also it’s costly and time-consuming.
And most importantly – bad news tends to cluster.
The very time when a bank’s borrowers are defaulting en masse on their mortgages will invariably be a terrible time for the economy more widely – and probably for house prices, too.
Banks could be seizing and selling properties into a falling market (as they did in the early 1990s).
Which means that in a steep house price crash, the bank could fail to recoup the money it had lent out against the mortgage when it sells. Especially once all the various costs are factored in.
And again, despite how it looked in 2008, banks don’t really want to be losing money on one of their main lines of business.
The loan-to-value ratio and interest rates
Obviously this unhappy loss-making outcome is more likely when the mortgage made up most of the money used to buy the property.
In other words – when the purchase was at a very high loan-to-value ratio.
In that case, the equity in the property – the difference between the house price and the mortgage – is very small. There’s not much safetly buffer, from the bank’s perspective. So little in fact that after a house price crash it could be wiped out and even go negative. (Hence the term ‘negative equity’.)
To reflect this risk of losing money on small deposit house purchases, banks charge greater interest rates on their higher LTV mortgages.
At the very highest LTV levels – where the borrower puts down just a 5% deposit or maybe nothing at all – rates will be far higher than for borrowers with a chunkier deposit who borrow from the same bank.
Banks typically obfuscate all this with their mortgage filters and other tools. But a few do make it admirably plain via downloadable lists of all their products.
Here’s an example of what we’re talking about:
Source: Virgin Money
Here the mortgage rate falls by 0.24% for buyers who put down an extra 20% deposit, meaning their LTV ratio is 65% compared to 85%.
On a £300,000 mortgage, that’d be a difference of £42 a month, or £2,520 over five years. Not enormous, but certainly worth having.
But the LTV bands in this example are very wide. You’ll find them stepping down in 5% increments with some lenders.
In my initial example, for instance, Richard was originally borrowing on a LTV ratio of 95%. His bank was looking to charge him 5.75% over five years.
By putting in a little more cash, Richard dropped to an LTV ratio of 90%. The interest rate in that band was a far cheaper 5.04%. Which was what made for the vast savings we saw over five years.
Mind the cliff edge
You might say this isn’t rocket science – and I agree, it’s not – and that if you had an extra 20% of the purchase price to casually reduce the size of your mortgage, you’d do it already.
Fair enough – but that’s not what I’m talking about.
The point is these LTV bands are arbitrary and typically pretty rigid.
Again, Richard he didn’t have to put down an extra 5% deposit to drop into the much cheaper mortgage bracket.
His deposit was already big enough such that his LTV ratio was only slightly above 90%. Putting in just £2,000 to get the LTV ratio below 90% is what unlocked a cheaper rate and saved a fortune.
The return on those marginal pounds was enormous, as I showed above.
Now, many of the sort of people who read Monevator will find this obvious. Which reminds me of my former housemate, Nat, who I used to compete with while watching Who Wants To Be A Millionaire?
Nat was never very self-aware about this – even when I pointed it out to her – but there were only two categories of questions in this quiz as far as she was concerned.
“Too easy, everyone knows that!” (when she knew the answer) or “Impossible, that is so obscure!” (when she didn’t).
Similarly, all this may be obvious to some, but others aren’t used to thinking about money this way.
In my experience people often have, say, a pot of cash for the house deposit, and another pot set aside for furnishing the property or for buying a car or simply labeled as nebulous ‘savings’.
Depending on how close to the LTV ‘cliff edge’ they are, it could make much more sense to add that money to the deposit, unlock a cheaper mortgage, and to then use say a 0% credit card to furnish the new home. (Provided they can trust themselves to pay it off, of course!)
Alternatively, they might employ removal boxes as furniture like I did when I bought, and gradually furnish their new home out of the cashflow freed up by the resultant cheaper mortgage!
A few final pointers about loan-to-value ratios
With so much financial business done online nowadays, I suspect a lot of people simply click through a mortgage comparison site with little idea about the loan-to-value ratios driving the rates their offered – let alone how much they might save by putting down a little bit more as a deposit.
So a few concluding thoughts about tweaking mortgage bands via the LTV ratio:
- Can’t increase your deposit? Maybe you can get into a lower band by driving a slightly harder bargain when you buy your home. Remember it’s the ratio that matters.
- Your loan-to-value ratio will have changed by the time you remortgage. A repayment mortgage reduces the size of the mortgage balance over time. If house prices rise your loan-to-value will fall further.
- Also look out for any opportunity to nudge yourself into a more favourable band when you remortgage by making over-payments.
While we’re on the subject, these sort of cliff edges pop-up elsewhere in personal finance. So stay alert.
You’re looking for marginal edge cases, where a small additional amount of money or some other tweak to your financial posture generates outsized returns.
For instance, increasing your pension contributions can enable you to retain your child benefit if it reduces your income below the critical threshold – a win-win.
Paid to play
It’s pretty dopey these arbitrary bands with critical thresholds still exist for mortgages. Not to mention other areas like stamp duty – and arguably even income tax.
Simple bands made sense when everything was worked out with a slide rule. But what’s the justification now? It’s all done by computer.
Ideally each of us would be offered a bespoke mortgage rate. This would reflect every facet of our unique financial situation. Such individualized underwriting would be fairer on borrowers – and perhaps safer for the banks as well.
Maybe lenders worry that bespoke deals – or even just narrower loan-to-value bands, with say 1% increments – could confuse us? Or even lay them open to mis-selling claims?
Whatever the reason, for now it pays to pay attention to the small print.
Got a favourite example where some marginal additional pounds unlock outsized benefits? Please share all in the comments below!
