Best Of The Hotline: Max LTV – An Appraisal Contingency?

By James L. Goldsmith, Esq.

There are a number of moving parts in our standard mortgage contingency clause: the amount to be financed, interest rate, loan terms, points and the maximum loan-to-value (LTV). These variables are intended to work in harmony to identify loan terms acceptable to the buyer and to allow a buyer to terminate a transaction if the committed loan does not meet the parameters established by the clause. When it comes to filling out the mortgage contingency clause, few realtors are confused about identifying the interest rate, term, loan amount or points. That is far from the case when it comes to understanding what to use as the maximum LTV. Consider the following:

Using a PAR Standard Agreement, the parties negotiated a sale for $327,000. The buyers had cash assets and only needed to borrow $177,000. That number was inserted by the buyer agent in the mortgage contingency clause as the loan amount. The buyers and their agent were also able to identify the appropriate interest rate, term and maximum points. As for the maximum LTV, the agent inserted "80 percent." The buyer's agent used this number because she did not want her buyers to have to go through with the purchase if the property didn't appraise at the full purchase price, and 80 percent was the number that she had been told to use in the past.

The property appraised for $225,000 and NOT the $327,000 purchase price! Because the property "did not appraise," the buyers directed their agent to prepare a notice of termination that was sent to the listing agent. The listing agent responded that the buyers had no right to terminate the agreement and that if they did not purchase the property, the sellers would keep their $10,000 deposit.

Q. Did the failure of the property to appraise at the contract sales price entitle the buyers to walk?

A. No. Those of you who have reached for calculators probably had no difficulty coming up with the answer. However, those who may be using gut instinct are more likely to believe that the buyers should not be required to proceed. For many, an 80 percent LTV is the magic number to insert, and much of the time it works. It works when the buyer seeks a loan that is 80 percent of the purchase price. Then, if the property appraises for a dollar less than the purchase price, that same loan amount will represent a greater percentage of that slightly reduced fair market value, voila´.

Let's do the math for our example. The purchase price was $327,000 and 80 percent of that number is $261,600. But that number is completely irrelevant because the buyers were not seeking to borrow $261,000! The first thing our agent should have done was compare the loan amount the buyers were borrowing ($177,000) to the purchase price ($327,000). To turn this comparison into a percentage, divide the amount to be borrowed by the purchase price ($177,000 divided by $327,000 = 55 percent (rounded to the closest single digit)). In other words, the buyers' agent should have provided that the LTV ratio would not exceed 55 percent. (Another way to describe this number is the "loan-to-purchase price" because we have not yet had the property appraised, and we do not know its value.) But remember, our goal is to assure that the value assigned by the appraiser is no less than the purchase price.

Had the buyer agent inserted 55 percent for the maximum LTV, the transaction would have unwound differently. The appraised value came in at $225,000, and despite this shockingly low number, the lender still committed to the $177,000 loan. We now need to see whether the loan of $177,000 exceeds 55 percent of the actual value as assigned by the appraiser. The math is (once again) simple. Take the loan amount and divide it by the appraised value ($177,000 divided by $225,000 = 79 percent (rounded to the nearest single digit)). Ah ha, the loan-to-value in this transaction is 79 percent and exceeds the 55 percent LTV the buyers sought. The buyers therefore can walk and get all of their deposit money back.

Another way to accomplish the goal of ensuring the appraised value was not less than the purchase price would be to use the appraisal contingency addendum. Keep in mind that using more addenda is not necessarily the best strategy for a buyer, and understanding how to use the LTV provision in the mortgage contingency clause can quietly but effectively ensure the buyer will not have to buy if the appraised value of the property is less than the purchase price. Regardless of the method employed, one must be conversant with the maximum LTV provision of the mortgage contingency clause.