What is a High Ratio Loan?
A high ratio loan is a loan whereby the loan value is high relative to the property value being used as collateral. Mortgage loans that have high loan ratios have a loan value that approaches 100% of the value of the property. A high ratio loan might be approved for a borrower who is unable to put down a large down payment.
For mortgages, a high ratio loan usually means the loan value exceeds 80% of the property’s value. The calculation is called the loan-to-value (LTV) ratio, which is an assessment of lending risk that financial institutions use before approving a mortgage.
Mortgage loans can be categorized into high-ratio loans and low-ratio (conventional) loans. When the ratio exceeds 80%, the loan is considered to have a high ratio. High-ratio loans come with a higher level of risk than conventional loans. Thus, lenders usually expect to be compensated with higher interest payments, especially when the borrower’s credit score is low.
Borrowers who cannot afford a large amount of down payment (conventionally 20% of the property value) need to borrow a high-ratio loan with an LTV ratio above 80%. The Federal Housing Administration (FHA) offers loan programs that make high-ratio loans available to borrowers. The program requires a minimum down payment of 3.5%. This means that the LTV allowed by the FHA loans can be up to 96.5% (100% – 3.5%).
- A high-ratio loan is one where the loan’s value is large relative to the property value being used as collateral.
- A high-ratio loan usually means the loan-to-value (LTV) exceeds 80% of the property’s value and may approach 100% or higher.
- Mortgage loans that have high loan ratios can be quite risky, and carry above-average interest rates.
The Formula for a High-Ratio Loan using LTV
Although there’s no specific formula to calculate a high ratio loan, investors should first calculate the loan-to-value ratio in their situation to determine if the loan exceeds the 80% LTV threshold.
For example, a borrower plans to make a $300,000 down payment to purchase a house with an appraised value of $1,000,000. The rest, $700,000, will be financed through a mortgage loan. It results in an LTV ratio of 70% (700,000 / 1,000,000), which is lower than the 80% threshold. Thus, the loan can be considered a conventional loan.
If the borrower plans to make a downpayment of $100,000 for the same house, the LTV ratio increases to 90% with a mortgage amount of $900,000. This brings up the mortgage to the high-ratio loan category.
What Does a High LTV Ratio Loan Tell You?
Lenders and financial providers use the LTV ratio to measure the level of risk associated with making a mortgage loan. If a borrower can’t make a sizable downpayment and as a result, the loan value approaches the value of the appraised value of the property, it’ll be considered a high ratio loan. In other words, as the loan value gets closer to 100% of the property value, lenders might consider the loan too risky and deny the application.
The lender is at risk of borrower default particularly if the LTV is too high. The bank might not be able to sell the property to cover the amount of the loan given to the defaulted borrower. Such a scenario can easily occur in an economic downturn when housing properties typically decrease in value.
If the loan given to the borrower exceeds the value of the property, the loan is said to be underwater. If the borrower defaults on the mortgage, the bank will lose money when they go to sell the property for a lower value than the outstanding mortgage balance. Banks monitor LTV to prevent such a loss.
As a result, most high ratio home loans require some form of insurance coverage in order to protect the lender. The insurance is called private mortgage insurance (PMI), which the borrower would need to purchase separately to help protect the lender.
Limitations of High-Ratio Loans
A higher LTV ratio represents a lower amount of down payment and a higher level of lending risks. Banks may refuse to lend or ask for a higher interest rate in the case of high-ratio loans.
The highest LTV ratio that a high-ratio loan can reach is 100% theoretically, which means no down payment is made, and all the property will be purchased entirely through borrowing. However, it happens rarely in the real world due to the extremely high credit risk.
Many institutions do not offer mortgages with high LTV ratios. Different institutions impose different upper limits depending on their mortgage program policies. Extra limitations or requirements are usually set for high-ratio loans to mitigate the high risks.
Higher credit scores and private mortgage insurance (PMI) are two common examples. PMI protects the lenders in the case that borrowers default. Borrowers typically must pay premiums for the mortgage insurance when the down payment is below 20% of the purchase price (high-ratio loans).
Although the premiums for PMI increase the borrowing costs, they offer borrowers who cannot afford a 20% down payment opportunities to purchase houses. As the mortgage’s been paid down to an LTV ratio below 80%, the mortgage is no longer a high-ratio loan. The borrower is allowed to initiate a PMI cancellation and stop paying the premiums.
In the public sector, FHA offers high-ratio mortgage loans with an LTV ratio up to 96.5%, as mentioned above. However, for the purpose of risk control, the program sets a minimum requirement of credit scores for the higher ratio and requires a mortgage insurance premium (MIP).
Like private sector insurance, borrowers can refinance and remove the MIP when they’ve made regular repayments and brought the LTV ratio below 80%.
Example of a High-Ratio Loan
Say a borrower plans to buy a home that has a $100,000 appraised value. The borrower can only afford to make a $10,000 down payment, and the remaining $90,000 will have to be borrowed. After approaching several lenders, one finally agrees to underwrite a mortgage, but with a higher-than-average interest rate.
The result is a loan-to-value ratio of 90% or (90,000 / 100,000), which would be considered a high ratio loan.
High-Ratio Loans vs. Home Equity Loans
A home equity loan is an installment loan or a second mortgage that allows homeowners to borrow against the equity value in their residence. The loan is based on the difference between the homeowner’s equity and the home’s current market value.
A home equity loan is for those borrowers who already have a mortgage, and have paid down some of the mortgage balance, and whereby the property value exceeds the loan balance. In other words, a home equity loan allows homeowners to borrow based on the equity in the house. A high-ratio loan, on the other hand, can have a loan value that approaches 100% of the value of the property.