The loan-to-cost ratio compares the amount of a property loan to the costs of the associated project. It doesn’t factor in the expected value of the property after the project. The loan-to-cost ratio is a key factor in lending decisions, though you can take several steps to improve your chances of getting financing based on a higher ratio.
Loan-to-Cost Ratio Explained
Lenders use the loan-to-cost ratio when considering financing construction and improvement projects such as a fix & flip. This means the borrower plans to sell or rent the property at the end of the project rather than use it as their residence.
The ratio works very simply: it’s the amount of the loan expressed as a percentage of the total planned costs of the project. These costs include the initial purchase of the property (or land) and the construction, repair, or improvements.
For example, if somebody plans to pay $50,000 for land and a further $100,000 on materials and labour to build a property, they may apply for a loan of $120,000. This prospective loan would have a loan-to-cost ratio of $120,000 / ($50,000 + $100,000) = 80 percent.
Note that this calculation doesn’t take any account of how much the property is likely to fetch when sold.
How and Why Lenders Use the Loan-to-Cost Ratio
Many lenders use a set loan-to-cost ratio to decide the maximum amount they will lend on a project. In the above example, if a lender used a standard loan-to-cost ratio of 70 percent, the maximum they would lend is 70 percent of the $150,000 costs, meaning $105,000.
The primary reason for using a loan-to-cost ratio is to control how much money the borrower has to bring to the project themselves. In turn, this affects the division of risk between the lender and the borrower. This involves both the risk that costs are higher than expected and the risk that the completed property doesn’t sell for as much as anticipated.
The higher the loan-to-cost ratio, the more of the risk the lender bears. The lower the loan-to-cost ratio, the more likely it is that any shortfall is borne entirely by the borrower.
A secondary use for the loan-to-cost ratio is to take account of the borrower’s commitment. In theory, at least, the lower the loan-to-cost ratio (and thus the more money the borrower puts into the project from their own funds), the more incentive the borrower has to be certain the project is viable and well-managed.
Setting a Loan-to-Cost Ratio
A lender won’t necessarily use a single, unbreakable loan-to-cost ratio for housing loans. For example, they may have a policy to offer loans with a higher loan-to-cost ratio to borrowers who have experience with previous projects.
Another option is to offer loans at different interest rates depending on the loan-to-cost ratio. The higher the ratio, the higher the interest rate, reflecting the greater risk to the lender.
In some cases, the lender may offer a loan amount using a loan-to-cost ratio that depends on the specific details of the project.
How to Increase Loan-to-Cost Ratio
While some lenders may not budge on their maximum loan-to-cost ratio on a particular project, borrowers can take several steps to increase the likelihood of being offered a loan amount based on a higher loan-to-cost ratio. These include:
- Taking steps to improve their personal credit score.
- Showing a history of successful property projects where they repaid on schedule and kept to their original budget.
- Preparing detailed plans for the project with realistic estimates of the costs.
- Borrowing for projects involving projects that meet the lender’s preferences. These may include size, location, and expected timescale.
- Being willing to accept (and budget for) a higher interest rate.
- Comparing different lenders to find ones offering higher loan-to-cost ratios.
How Borrowers Can Use Loan-to-Cost Ratio
Would-be borrowers can approach the loan-to-cost ratio from a different perspective to assess the viability of a project such as buying a fixer-upper. After calculating the costs of a project, they can figure out how much money they are willing (and able) to put into it themselves. They can then calculate how much they’d need to borrow and thus the loan-to-cost ratio.
If this calculation produces a particularly high loan-to-cost ratio, it suggests the project may be difficult or expensive to fund through borrowing. This may affect whether it is either possible or worthwhile to proceed.
For example, compare a project with a $150,000 purchase price and a $100,00 rehab budget vs. a project with a $150,000 purchase price and a $30,000 rehab budget. If the lender is financing an 85% loan to cost as a maximum, then scenario 1 would give a loan amount of $212,500. 85% of $150,000 + $100,000). This would give a loan
Interaction With Loan-to-Value Ratio
Loan-to-cost is not the only measure property lenders use to calculate maximum home loans amounts. Many also use loan-to-value, which compares the loan amount to the expected amount the property will sell for at the end of the project. (This sale amount is sometimes called after repair value or ARV.)
Using a loan-to-value ratio is a way to assess and mitigate the risk that the property does not fetch as much money as expected and thus the risk that the borrower cannot afford to repay the full loan amount.
While every lender is different, a common approach is to calculate maximum loan amounts using both the loan-to-cost ratio and the loan-to-value ratio and then only lend up to the lower figure.
Your Next Steps
It can be confusing or overwhelming to figure out the best options for borrowing to finance a fix and flip. A private lender such as Lendmarq can help you assess whether your project is viable and get a loan at a favorable rate. Contact us today to start the process.