IMPACT OF LOAN-TO-VALUE RATIO ON MORTGAGE DEFAULT RISK

Abstract

With effect from 19 July 2005, the loan-to-value ratio (LTV) for both bank-originated and HDB-originated loans would be raised for the first time in 9 years from 80% to 90%. As most homebuyers take up one form of mortgage financing or another to finance their property purchases, this change in financing policy will have several implications for both the lenders and the borrowers. One such implication is the default risk. The paper thus seeks to analyze the impact of the LTV limit change on default option value and default risk of adjustable rate mortgages (ARMs) in home purchases by developing a binomial tree option-pricing model with two stochastic variables (interest rates and house price). The results evidence that the higher the LTV of a loan, the greater the default option value and in turn, a greater default risk. In addition, results of the sensitivity analysis conducted indicate that initial interest rate, initial house price, volatility of interest rate and volatility of house price are positively related while risk-free rate is inversely related to the default option value of ARMs. Hence, in anticipation of the potential increase in default risk, implications for the lenders and the borrowers should not be disregarded. These justify further research in this study.