Collateral is the security for the loan, normally the property over which a mortgage will be applied.
When assessing the security offered, a lender is establishing the probability of being able to sell the property at a price sufficient to recover the funds owed as well as outstanding interest and costs should the borrower default on the loan. Obviously, the lower the percentage of the value of the property borrowed, the greater the probability of recovering the outstanding debt.
Lenders set maximum percentages that they will advance against different types of properties in accordance with their assessed risk. This is known as the ‘loan to valuation ratio (LVR).
Most lenders will prefer maximum LVRs of 80%. A borrower can borrow a higher percentage of the property value by paying for the cost of Lender’s Mortgage Insurance (LMI). LMI is an insurance policy to protect the lender from loss if the borrower defaults. The policy is in place to cover any shortfall between the amount which may be recovered from selling the security and the outstanding balance of the loan. This is potentially greater in the early years of a loan where the LVR is high. The LMI premium is usually based on a % of the loan amount.
It does not protect the borrower. If a loss resulted because a property had to be sold due to a borrower default, the borrower would still be liable for the loss and the insurance company would seek to be recompensed by the borrower after settling with the lender. Note that a lender can extend their request to have the outstanding debt satisfied by sale of any and all assets of the defaulting borrower. It is a mistake to believe that using a strategy which does not cross collateralise securities will protect the other assets of the borrower.
Lenders and mortgage insurers vary their maximum LVRs according to the loan amount, type of property, nature of title, location of property and credit history. In addition to this, the LMI premium (paid by the borrower) becomes a greater percentage of the total loan amount as:
- the loan amount increrases and
- the more the LVR increases beyond 80%.
Hence, at 81% LVR a premium may be.0.5% of the loan amount, while at 91% it may be 1.2%. This higher percentage represents the significantly higher risk for the lender of a higher LVR.
Most lenders will lend up to 80 per cent of the value of a residential property without charging the customer LMI and 95 per cent with LMI, provided the property is in a major area with populations exceeding 8000. For properties outside the metropolitan areas of a major city or a large regional centre, lower LVRs and/or lower maximum loan amounts may apply.