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Understanding Loan to Cost Ratio Versus Loan to Value Ratio for Construction Loans

Understanding Construction Loans Cost Ratio Versus Loan to Value Ratio

Today we are going to cover the differences between a loan to cost ratio and a loan to value ratio when buying land to build a custom home. We will also consider how the bank views these ratios, how the ratios affect the required down payment, and how that affects the loan amount.

Loan to Cost Ratio

The Loan-to-cost ratio factors in the cost of land, soft costs, and hard costs. Soft costs include intangible fees such as design, permits, engineering, etc. Hard costs account for the actual construction of the home and site improvements. The bank considers these three components as the cumulative total cost of a project. The bank has a ratio that they will lend on. That ratio typically rises to 80% loan-to-cost, or LTC.

On a $1 million project, $200,000 of that could be for the land, $100,000 could be for the soft costs, and $700,000 could be for the hard costs. Using a loan-to-cost ratio, the bank will multiply $1 million times 80% and determine that they can offer an $800,000 loan, which would require a $200,000 down payment to start the project.

When Does the Bank Use a Loan to Cost Ratio?

This scenario typically applies with banks once you find a piece of land and you use the construction loan on the first draw to both pay the land and fund the construction improvements. Borrowers do not technically own the property in this instance prior to closing on this construction loan, which makes LTC very common. A great way to retain land ownership is to use a loan-to-value ratio. To recap, a one-million-dollar LTC at 80% will result in an $800,000 loan accompanied by a $200,000 down payment.

Loan to Value Ratio

In a loan-to-value scenario, using the same 80% ratio example, at $1 million dollars, the appraiser that’s hired by the bank will evaluate the comparable properties to the home you want to build. They will prepare an after-build value that the bank can use to determine a value for the property. 

Let’s assume in this scenario that the appraised value of this property equates to an appraised value of $1.2 million. Multiplying the $1.2million times 80% gives us a new loan amount of $960,000 and a required down payment of $40,000. This significantly lowers the down payment amount by $160,000 if we’re able to use the loan-to-value instead of a loan-to-cost ratio. This can be very beneficial if you’re trying to keep more money in your pocket.

When Does the Loan to Value Ratio Apply?

To accomplish this, you must take the title to the land prior to applying for the construction loan. When buying land, if you have cash or can get a land loan, you need to open a separate escrow, purchase the land, close on it, and get it titled in your name. Once the land is titled in your name, you can apply for the LTV construction loan.

Seasoning Period Required by Some Banks

Some banks require a seasoning period. You may have to wait a certain amount of time after you close on the land to close on the construction loan. One bank that we work with only requires a day. The seasoning period can be a day, or it can be a few months. This period simply depends on the individual bank. This is a great advantage to use if you want to use less of your own money in your project.

Additional Resources for Buying Land and Building a Home

I hope that helps clarify the difference between a loan-to-cost and a loan-to-value and how they can help obtain a construction loan when buying land. If you’d like more information, please review our website. We have lots of information for download regarding the cost to build a home and how to buy land along with plenty of other information under our resources tab. Thanks for your time today and have a great rest of your day.

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