When you obtain a mortgage loan to purchase a home, the collateral used to secure the loan is the house. If you fail to make payments and default on your loan, your lender has the option to claim ownership of the house due to its security interest.
Collateral = your home – this is the what secures the mortgage loan in case you don’t make your payments
While property type and occupancy are important considerations for lenders, the value of the property is the most important part of collateral. The chief concern is that the property is worth enough to easily be sold to recoup losses should there be a default on the mortgage loan.
The value of the property is the most important part of collateral.
Quick Facts video 4: How collateral impacts your ability to qualify for a mortgage loan
Licensed appraisers estimate the value of a property by comparing it to recently sold properties in the neighborhood, generally within the last 6 months. These comparable houses are similar with respect to land, square footage, total rooms, bedroom count, age, and general appeal.
Recently sold properties in your neighborhood that are similar to the home to be financed are used by appraisers to help determine its value.
What is LTV or Loan-to-Value?
LTV or Loan-to-Value ratio = amount being borrowed/ value of the home
Once the property value is determined, it is used to compute loan-to-value which is the amount being borrowed divided by the value of the house. For example, if a home is valued at $250,000 and the mortgage loan is $200,000, the LTV is 80%.
$200,000 / $250,000 = 80% LTV (Loan-to-Value ratio)
If a second mortgage for $25,000 is on the home as well, then the combined loan-to-value, or CLTV, is 90%.
$200,000 first mortgage loan + $25,000 second mortgage = CLTV of 90% ($225,000 / $250,000)
The higher the LTV, the greater the risk because the likelihood of a loss in the event of default goes up. Consequently, if a higher LTV means higher risk, it also will generally mean a higher rate for the borrower, or in some cases, a higher one time cost, or higher monthly costs.
A higher LTV or CLTV = higher risk to the lender = higher the cost to the borrower
In order to compensate for increased risk, most lenders will require mortgage insurance?
Mortgage Insurance (MI)
Mortgage Insurance (MI) is used to compensate for increased risk of default.
Properties with Loan-to-Value ratio’s over 80% typically require mortgage insurance, or “MI” of some sort. Usually the cost of the mortgage insurance is passed on to the borrower as an added expense on their monthly mortgage payment.
LTV’s over 80% almost always require MI, this will usually be added to your monthly payment.
You will need to budget for MI in your monthly payment if you are financing more than 80% of your home.
monthly payment = interest + principle + escrow ( taxes and insurance) + mortgage insurance
So to wrap up collateral, the more you owe on your home, the more risk there is to the lender, the more you will pay. So plan accordingly.
With respect to collateral, a larger amount owed = higher lender risk = higher borrower cost.
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