Real Estate Salesperson · Financing and settlement · 8 min read
Loan to Value, Mortgage Insurance and Discount Points
- Calculate the loan-to-value ratio using the purchase price or appraised value and assess how equity and down payments affect lender risk.
- Explain the purpose of private mortgage insurance and apply the Homeowners Protection Act rules for borrower-requested cancellation and automatic termination.
- Determine the cost and function of discount points, compare permanent and temporary buydowns, and identify lender property insurance and escrow requirements.
Loan-to-Value Ratio and Homeowner Equity
In residential mortgage financing, the loan-to-value ratio, commonly called LTV, is the percentage of a property's value that a lender agrees to finance. For a typical purchase loan, the lender calculates LTV by dividing the loan amount by the lower of the purchase price or appraised value; for a refinance, LTV is generally based on the property's appraised value. The down payment is the portion of the purchase price paid in cash that is not covered by the mortgage loan. Because state laws and specific contract requirements vary, real estate salespersons working under their supervising brokers frequently guide buyers through how these basic numbers interact during transaction negotiations.
From a lender's perspective, a higher loan-to-value ratio represents greater financial risk. Conversely, a lower loan-to-value ratio generally means the borrower has more initial equity in the real estate, meaning the lender faces less risk of loss if the borrower defaults. Equity is defined as the difference between the fair market value of a property and the total balance of liens against it. For instance, when a buyer provides a 20 percent down payment, a loan financing the remaining 80 percent of the purchase price results in an 80 percent loan-to-value ratio, assuming the lender uses the purchase price as the property value. In contrast, with a 10 percent down payment, a loan financing the remaining 90 percent of the purchase price creates a 90 percent loan-to-value ratio under the same valuation assumption.
Complications can arise when an appraisal comes in lower than the agreed contract purchase price. In this scenario, the lender bases the loan-to-value ratio strictly on the appraised value rather than the higher contract price. When an appraisal is lower than the contract price, the buyer may need to provide additional cash or arrange a different loan structure, the parties may negotiate a lower purchase price, or the buyer may exercise an appraisal contingency if the purchase agreement provides one and its specific requirements are met.
Over time, property appreciation increases homeowner equity. If the mortgage loan balance remains unchanged, this appreciation lowers the loan-to-value ratio when calculated using current market value. However, candidates must note that market appreciation does not change the property's original value used for certain statutory mortgage insurance cancellation rules.
| Down Payment Percentage | Resulting Loan-to-Value Ratio | Private Mortgage Insurance (PMI) Status |
|---|---|---|
| 20 percent | 80 percent | Typically not required on conventional loans |
| 10 percent | 90 percent | Typically required on conventional loans exceeding 80 percent LTV |
| Under 20 percent | Over 80 percent | Typically requires PMI or another lender-approved way to address higher risk |
Common mistakes
- Calculating discount points or loan-to-value ratios using the purchase price when an appraisal is lower or calculating points as a percentage of the purchase price instead of the loan amount.
- Believing private mortgage insurance protects the borrower against default or acts as casualty and liability insurance, when it solely protects the lender against financial loss.
- Assuming that standard hazard insurance policies cover flood damage or that flood insurance is required in all areas regardless of FEMA Special Flood Hazard Area designations.
- Expecting private mortgage insurance to automatically terminate at 78 percent LTV simply because the borrower made extra principal payments, rather than waiting for the scheduled termination date.
Key points
- For a typical purchase loan, LTV measures the loan amount against the lower of the purchase price or appraised value; for a refinance, it generally uses the appraised value. A higher LTV generally represents greater risk to the lender.
- Conventional loans with an LTV exceeding 80 percent typically require private mortgage insurance (PMI) to protect the lender against loss if the borrower defaults.
- Under the Homeowners Protection Act, borrowers may request PMI cancellation at 80 percent of original value with a written request and good payment history, while automatic termination occurs when scheduled to reach 78 percent if current.
- Each discount point costs one percent of the loan amount and represents prepaid interest that can permanently buy down the note rate and increase the lender's yield.
- Hazard insurance covers specified structural perils based on replacement cost, while standard policies exclude flood damage.
- Flood insurance is generally required when a building in a FEMA Special Flood Hazard Area secures a covered federally backed or federally regulated loan and the applicable flood-insurance availability requirements are met; applicable rules may also require escrow, and a lender may force-place coverage if required insurance lapses.
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