The loan-to-cost ratio (LTC) measures the percentage of a property’s acquisition, rehab, and construction costs that’s financed by a loan. It is typically used for commercial mortgages, fix-and-flip loans, and construction loans. The LTC helps investors set budgets for their down payment and expected monthly payments and calculate potential profits.
Loan-to-Cost Ratio (LTC) Formula
Calculating the loan-to-cost ratio is relatively simple. You derive LTC by taking your estimated loan amount and dividing it by your total acquisition, construction, and/or renovation costs.
The loan-to-cost (LTC) formula is:
LTC = (Loan Amount) / (Total Project Cost)
Loan Amount
Loan amount is the amount of money you borrow from a lender. The maximum loan amount is typically determined by the lender based on several factors, including property type, borrower qualifications, type of loan, and more. Lenders would normally set a maximum loan amount equal to a percentage of LTC but will also have a cap on the maximum dollar amount of a loan.
Total Project Cost
The total project cost of a property includes the whole cost of acquiring the property such as the purchase price, cost of documentation, and other miscellaneous expenses. If the loan is for the construction or renovation of a property, then the construction and renovation costs are also added to the acquisition cost of the project.
It is important to note that actual costs are taken into consideration. The value (either appraised value, fair market value, or after repair value) of the property has nothing to do with calculating the loan-to-cost ratio. When the property’s value is being considered to determine the size of loan, the loan-to-value ratio is used.
Why the Loan-to-Cost Ratio Is Important
The loan-to-cost ratio is important because it helps to determine the size of a loan based on the actual costs of the completed project. Borrowers use their LTC rates to set a maximum budget and determine their out of pocket costs such as down payment as well as ongoing expenses like monthly loan repayments.
The loan-to-cost ratio is normally used by short-term fix-and-flippers to purchase, rehab, and sell a property within a year. However, long-term investors and primary owner occupants sometimes use the loan-to-cost ratio to purchase, renovate, and/or build a new property before refinancing to a permanent loan. The LTC is also used by developers when financing a new development project with a construction loan.
Most lenders will set a maximum loan amount in dollars as well as cap the maximum LTC rates (e.g. up to 75% LTC or up to $100,000, whichever is lower). Basically, if a borrower hits a lender’s maximum LTC or dollar amount limit, they’ll have to invest more money into the project.
A higher loan-to-cost ratio means that the lender is taking more risk to fund the project. Because of this, interest rates might be higher and you might need mortgage insurance. A lower LTC means that a smaller percentage of the project’s cost is being financed. This lets the borrower make a higher down payment, but it also means fewer financial obligations when it comes to the monthly principal and/or interest payments.
Let’s take a look at the following example for a better understanding:
A property’s purchase price is $100,000. Additional cost for repairs and improvement are estimated to be $20,000. The current appraised value of the property is around $150,000, and you’re expecting it to go as high as $170,000 after rehab. With this, your total cost is $120,000. If the lender agrees to finance up to 75% LTC, you will get a $90,000 loan and cover the remaining $30,000 yourself.
However, future actual costs for construction and renovation can be higher than your estimated costs. Continuing the example, let’s say you expected to spend $20,000 for improvement but the actual repair cost turned out to be $50,000. This increased your total cost to $150,000. Since the lender agrees to finance up to 75% LTC, this means that up to $112,500 of your costs will be covered by a loan while you shall cover the remaining $37,500 out-of-pocket.
Pros and Cons of Using Loan-to-Cost Ratio
The loan-to-cost ratio is one method of measuring the size of a loan when financing a real estate project. Other ways include the loan to value (LTV) ratio or after repair value (ARV). Using LTC to determine maximum loan rates and to set budgets therefore has its pros and cons.
Pros of Using LTC:
- The size of the loan is based on the actual total cost of the project rather than the appraised value, making it a more accurate measure for lenders.
- Using LTC ensures that the borrower gets funded based on what they are actually expecting to spend for the project.
Cons of Using LTC:
- The actual cost of the project’s construction and renovation costs may be difficult to determine at the beginning.
- In some cases loan amounts based on LTC may be smaller than loan amounts using ARV because a property’s estimated after repair value can be significantly higher than the cost of acquisition and repairs (cost).
How to Increase LTC
Many people want a higher loan-to-cost ratio because it helps them finance a larger portion of their property’s total cost and also helps them purchase larger properties. However, a lower LTC isn’t a bad thing. In fact, some people prefer a lower loan-to-cost because it results in a lower financial obligation and lower monthly costs.
Lenders typically set the maximum LTC rates for a project based on several factors. And as a borrower, you can address these factors ensure that you get a higher possible loan-to-cost ratio.
Below are three ways to increase your loan-to-cost ratio:
1. Improve Your Borrower Qualifications
Borrower qualifications are one of the most important factors that lenders look at when approving a loan. More qualified borrowers typically get approved for a higher LTC because lenders feel comfortable that they can repay the loan on schedule. If you want to get qualified for a higher loan-to-cost ratio, try to improve qualifications such as your personal credit score, financial status, debt service coverage ratio (DSCR), business experience, and more.
2. Look for Quality Properties
Because the property itself is often used as collateral, lenders also sometimes base LTC rates on specific property characteristics. For example, they consider such things as the property type, location, and the expected construction/renovation costs and timeline.
For fix-and-flips, they want to know how quickly the property can sell after the rehab. For buy-and-hold investors, lenders typically want to know how likely the property will be rented out after the completion of the project, including occupancy rates and seasoning.
3. Compare Different Loans and Loan Providers
Different lenders offer different loans and loan limits. For example, some lenders may be more willing to provide a higher loan-to-cost ratio than the others on their portfolio loans. There are other loan options to consider such as SBA loans, HELOC, hard money loans, FHA, and more. These loan types may offer higher or different LTC limits.
Bottom Line
Loan-to-cost ratio (LTC) is used to determine the percentage of a property’s purchase price and renovation/construction costs that are financed by a loan. Often, the actual loan amount can be increased depending on the actual cost of the project as a whole. A high LTC can be risky for lenders, and therefore it normally comes with higher interest rates and qualification requirements.
