Learn the loan to cost (LTC) meaning, how it works and whether it's for you before getting a mortgage.
There are various formulas in real estate concerning different parts of the homebuying/selling process. They help determine how much a buyer potentially qualifies for, the down payment, capitalization rate and more. Loan-to-Cost (LTC) and Loan-to-Value (LTV) are two common formulas. Read on to learn loan to cost meaning, when to use LTV and LTC and the differences.
Lenders generally try to reduce how much they advance a borrower to mitigate risks. This is where the LTC ratio can determine the risk of a potential real estate investment. Lenders often use the LTC to avoid putting up all or almost all the project costs (generally financing up to 80%). Since the borrower uses their own money, they may be more motivated to carry out the project successfully.
LTC is usually used in commercial mortgage cases of rehabilitation loans and construction loans, and concerns the costs of acquisition and construction or renovation. In addition to these costs, lenders look into other property factors such as location, land value and even the quality of the builders. The lender may also consider the borrower’s credit and loan history.
The higher the ratio, the higher the risk. Borrowers can determine how much they need to contribute to complete the project and how it compares to a lender’s maximum LTC.
Loan to cost formula
Loan amount / Total project cost
To calculate the LTC, divide the loan amount by the total project cost. For example, if a construction project costs $10,000 with a $6,000 loan, the loan-to-cost is 60% because it’s the project’s total cost divided by the loan amount.
What is Loan-to-Value in real estate?
The LTV ratio has to do with the loan size and how it compares to the value of the financed property. The lender provides the valuation, but an independent, certified appraiser carries it out. The appraiser looks at factors such as the expected revenue from the commercial building and the value of similar properties in the area. If necessary, you can ask for a second opinion from another appraiser to ensure the info is as accurate as possible.
The LTV determines factors such as the size of the down payment, loan payment and interest rate. A lender’s maximum LTV ratio will depend on the loan type and the borrower’s qualifications. This is why most mortgage lenders only accept projects with LTV ratios at or below 80, while it can go up to 100% for other loan types.
A low LTV can mean lower payments and interest rates, but a higher LTV can mean a lower down payment and a higher loan amount to cover more costs.
Loan to Value formula
Loan amount / Property’s appraised value
To calculate the LTV, divide the loan amount by the property’s appraised value. An example is a $150,000 loan on an apartment with an estimated future value of $200,000 based on the tenants’ rent. Divide $150,000 by $200,000 to get a loan-to-value of 75%.
LTV vs. LTC: What’s the difference?
“A lot of investors use the terms LTC and LTV interchangeably and they are not the same,” said Codie Fisher, a commercial lender and real estate investor affiliated with W2 Capitalist. “LTC refers to the max percentage that a lender will lend based on the cost of your project. Adding the purchase price and total amount of rehab together is how you calculate your total cost. LTV is the amount your property will be worth once the rehab is complete and typical rents have been raised.”
The main similarity is that both ratios mitigate the risk of a potential investment. One main difference is that LTC refers to the entire real estate project cost, while LTV is its market value. Another difference is lenders mainly use LTC to be conservative in the underwriting process, while LTV can result in a higher loan amount.
Because LTC is regarding an ongoing construction process, lenders tend to be more involved. Lenders will know how improvements are being carried out to ensure their investment is worth it. An ideal LTV, on the other hand, comes with freedoms such as avoiding paying mortgage insurance.
When to use LTV and LTC
The LTC ratio is more helpful when there are many ongoing costs involved, as with a construction project, because it helps determine the risk accurately and shows how feasible the deal is. If the asset is ready with no ongoing construction costs, the LTV ratio makes more sense since it is weighing its value.
Using the LTV for loans for property purchased at a significant discount is also better. Due to the higher market value, the LTV ratio will make the deal seem more feasible. On the other hand, the LTC ratio will be high and make the deal seem risky since the borrower isn’t putting up a lot of their own money.
LTC and LTV aren’t the only calculations. Lenders usually only receive the lesser of the various amounts. After Repair Value (ARV) refers to the value of a property after completion of the work. Usually, borrowers receive a percentage of this value, and the lender holds the remaining funds in escrow. “If a lender gives you a quote at 80% LTC subject to 70% of the ARV, it’s 80% of your total project cost, as long as that doesn’t exceed 70% of the ARV. An appraiser will base the ARV on your scope of work and projected new rental amounts,” Fisher said.
Along with the other formulas, the LTV and LTC work together to allow lenders to look at all possible angles of a transaction. It’s ideal when the LTV based on the future value is significantly lower than the LTC.