Loan to Cost vs. Loan to Value – What’s the Difference?
If you’re new to real estate investing, you may be wondering the difference between Loan to Cost vs. Loan to Value. The terms may seem interchangeable, although they’re anything but! The Loan to Cost ratio uses an investment’s true, paid-for price to determine a loan ratio, while the Loan to Value ratio uses your investment’s appraised value to determine the loan ratio. Some may say that these terms can be used interchangeably, but in reality, Loan to Cost and Loan to Value are different (and both important) factors that should be considered when making a real estate investment decision!
What is Loan to Cost?
Loan to Cost is the amount of money loaned vs. the price you pay for the house. If you buy a starter home for $100,000 and are loaned $80,000, your Loan to Cost (LTC) will be 80%. This is the ratio used by traditional lenders and banks when loaning money, because they assume the most recently paid price for the property (the price you paid) is the most relevant and true data point for the property’s true value.
Loan to Cost ratio is the most widely used ratio when lenders review your loan request. They will take the price you paid as the most up-to-date price information on the property and act accordingly when issuing your loan. Traditional lenders use Loan to Cost when issuing your loan, and typically require a Loan to Cost of 80% or less. You can get a Loan to Cost ratio of 95% or more in the home with certain programs like FHA, however.
What is Loan to Value?
Loan to value is similar to Loan to Cost, but not the same. Loan to Value uses the home’s true value as a metric when compared to the loan amount. Let’s say that the same starter home from the previous example has still been purchased for $100,000. The house may actually be worth $120,000, but the seller decided to sell their home on the cheap because they needed to leave the country quickly for… reasons. The value of the home (often determined by an appraiser before a home’s sale) will be used in the loan to value calculation. Now, you would divide the home’s value ($120,000) by the loan ($80,000) to get a loan to value of 66.6%. That’s quite the difference from the 80% loan to cost ratio!
What’s a good LTC and LTV ratio?
Assuming you are buying properties for under fair market value, your Loan to Cost ratio should always be higher than your Loan to Value ratio. That’s because the value of the investment property should be more than you pay for it (that’s the goal, at least!) If you overpay for a property, however, your Loan to Value ratio will be higher than your Loan to Cost ratio.
Good Loan to Cost and Loan to Value ratios are entirely relative to each investment and your goals. Less equity in a project is not always a good thing, and generally makes investments more risky… unless you’re ok with defaulting on your loan, that is! It’s best practice to do your due diligence and test multiple combinations of LTC and LTV in projections to see what makes the most sense for your investment project.
Which do Lenders Use
Loan to Cost and Loan to Value ratios are both used by investors and lenders to gauge risk in a project. In general, the more equity you’re willing to put in to reduce the loan’s Loan to Cost and Loan to Value ratios, the more “safe” the bank will consider the investment to be. Traditional large banks will only lend based on Loan to Cost, meaning that killer deal you found will not be factored into the loan terms.
Hard money lenders, like our site for example, will be much more willing to consider LTV when creating your loan package. Hard Money Lenders tend to look beyond the strict loan criteria of traditional banks and consider factors such as LTV when issuing loans. Using a Hard Money Lender may be a good option if you’re looking for loan terms that will benefit a fix-and-flip project or similar short-term investment.
Advantages of Using Hard Money Lenders
Hard Money Lenders will consider many more factors than traditional lenders when issuing loans to investors. Without a doubt, Hard Money Lenders are more friendly to the needs of investors and those with bad credit or no credit history. In the case of Loan to Cost versus Loan to Value, Hard Money Lenders will often consider both ratios when issuing your loan. If you can secure a fantastic deal on a property, Hard Money Lenders will be more open to issuing a favorable loan amount for your investment.
Since Hard Money Lenders use the underlying property as collateral for your loan, these lenders will take a closer look at the property you’ve chosen as an investment. If you can secure a great property in a desirable location for under market value, Hard Money Lenders will be very willing to work with you in determining loan terms that will help you close on your deal. Traditional lenders are much less concerned with the underlying property you’re purchasing, and more interested in your credit history, down payment, and due diligence on the property.
Can you get a 100% LTC or 100% LTV loan?
The elusive 100% loan-backed investment purchase is very attractive to investors, but rarely ever possible. Most lenders will want you to have some of your own equity in the project, or “skin in the game,” because they feel otherwise that the project is too easy to abandon. Without having some of your own equity, it’s very unlikely that you’ll receive any sort of backing — even with a very good loan to value ratio (i.e. finding a project for sale at way below market value).
Think about it this way — someone you don’t know comes up and asks you for some money. They have an amazing plan, tons of experience, and a go-getter attitude to match; only problem is, they want to use your money. Also, they won’t put in any money of their own. Wouldn’t that make you hesitant to loan this money out, even if the person asking was an experienced investor?
Still think you could secure a 100% LTC loan for your project? Read what we’ve had to say in more detail about this topic here!
When Will LTC & LTV Differ?
Assuming you buy your investment property at fair market value, there will be no difference between Loan to Cost and Loan to Value. That’s because “cost” and “value” will be exactly the same and divided by the loan amount you receive.
Where Loan to Cost and Loan to Value differ is when there is a disparity between the price you pay for a property and its value. If you find a fantastic deal and buy an investment property for $100,000 with a fair market value of $120,000, your Loan to Cost and Loan to Value ratios will differ.
When Should I Use LTC vs. LTV?
Loan to Cost and Loan to Value should both be considered when making an investment. Loan to Cost represents the actual amount of money being paid versus the loan amount — a much more concrete set of numbers than a loan to value appraisal. From one appraiser to another, loan to value can vary; with loan to cost, you’re using the most updated price information — the amount that you paid — into consideration.
High Loan to Value ratio projects, ones that are underpriced on the market, will help indicate how fast to move on a project. If you find a very high LTV project, you may want to snag it up before another investor does! At the same time, it’s worth it to take a few breaths and be thorough about your research into why that property’s underpriced on the market; could something be wrong?
In the end, both LTC and LTV should be considered when going into an investment. One metric, LTC, uses the properties’ purchase price divided by the loan amount. The other, LTV, uses the properties’ “true” or appraised value to measure against the loan amount.
Traditional banks will use LTC when creating your loan terms, while hard money lenders may offer loans based on LTV. Hard Money Lenders are more lenient and open than traditional lenders when giving favorable loan terms for great investment deals you find. But, if you’re looking for that rare 100% LTC loan, don’t hold your breath! They’re very rarely given out, even with a high LTV ratio.
When it comes to using LTC vs. LTV on your investment, do thorough research into the real value of the property the best you can and make your decision from there. Also, don’t forget to consider the dozens of other factors that go into an investment as well! There are many factors beyond LTC and LTV that make up an investment’s full picture.
Adam Smith has spent the last 5 years in the Private Money Lending world helping real estate investors secure financing for their non-owner occupied real estate investments. When he’s not thinking about real estate, Adam is an avid Jazz music fan and fisherman.