If you discussed a deal with a private lender, you might have heard a term “Loan-to-Cost Ratio.” Private lenders use the Loan-to-Cost ratio as a key underwriting metric to assess risk, determine loan amount, and evaluate the borrower’s commitment to a real estate project. It helps them make informed lending decisions and structure loans that align with their risk tolerance and lending criteria. However, many novice borrowers and some experienced investors do not exactly understand what loan-to-cost ratio is or how to calculate it. So let’s demystify it.
The Loan-to-Cost (LTC) ratio is a financial metric used in real estate and construction financing. It measures the proportion of the total project cost that is financed by a hard money loan. The formula for calculating the Loan-to-Cost ratio is simple:
LTC Ratio= Loan Amount / Total Project Cost×100%
In this formula:
- Loan Amount: This is the amount of money borrowed from a lender to fund a renovation project.
- Total Project Cost: This represents the entire cost of the project, including the cost of purchasing the property and renovation costs.
The LTC ratio is commonly used by private lenders to assess the level of risk associated with a particular rehab project. A higher LTC ratio indicates that a larger portion of the project is being financed through debt, which may be seen as riskier for both the borrower and the lender. Conversely, a lower LTC ratio means that the borrower is contributing more funds to the project, which can be viewed as a sign of financial stability and commitment.
Lenders typically have specific LTC ratio requirements for different types of real estate projects. These ratios can vary depending on factors such as the type of property, its location, the borrower’s creditworthiness, and the lender’s policies. It’s essential for real estate developers and investors to understand and manage the LTC ratio to secure financing for their projects effectively.
Private lenders use the Loan-to-Cost (LTC) ratio as an essential underwriting tool when evaluating loan applications for real estate projects. Here’s how private lenders typically use the LTC ratio in their underwriting process:
- Risk Assessment: Private lenders assess the LTC ratio to gauge the level of risk associated with a particular loan request. A higher LTC ratio implies that a larger portion of the project is financed through debt, potentially increasing the lender’s risk.
- Determination of Loan Amount: Private lenders often have specific LTC ratio requirements or guidelines. They calculate the maximum loan amount they are willing to provide based on these ratios. The loan amount is usually a percentage of the total project cost. If the borrower’s requested loan amount results in an LTC ratio that exceeds the lender’s acceptable threshold, the lender may require the borrower to reduce the loan amount and bring more money to the transaction.
- Assessment of Borrower’s Commitment: Often, a lower LTC ratio demonstrates that the borrower is committed to the project and has a significant financial stake in its success. This can be viewed positively by lenders, as it indicates the borrower’s willingness to share in the project’s risk.
- Project Feasibility: Lenders assess the feasibility of the project by scrutinizing the total project cost and comparing it to the loan amount requested. They want to ensure that the project is adequately funded to reach completion and generate the expected returns.
Bear in mind that loan-to-cost ratio is not the only criteria used to make a lending decision. Hard money lenders underwrite their loans differently compared to traditional lenders, such as banks or credit unions. Hard money loans are typically short-term, asset-based loans that focus more on the collateral (the property) then the borrower’s creditworthiness or financial history. Because private funds are used to finance the purchase and rehab of the distressed homes, the after-repair value of the property and the deal’s overall profitability are also big factors determining how much the lender is willing to lend and how much the borrower needs to bring to the transaction.
To better understand how we underwrite our loans, please refer to our hard money calculator. That easy-to-use illustrative tool will provide you with detailed and transparent blueprint on how we evaluate and stucture our private loans.