Loan to Value vs. Loan to Cost in Construction Financing

A construction loan is similar in many ways to a purchase loan or a refinance loan. The lender will be interested in your financial picture. They will need to establish your income and credit history just the same as if you were buying a property. But in addition to your credit they will need to look into the construction aspects of the scenario.

  • When did you acquire your property?
  • What did you pay for it?
  • What do you owe on it?
  • And, if you have owned the property for longer than 1 year, what is the property now worth?
  • What are your total costs to build the project, including permits, fees consultants and hard costs (but excluding any carry costs for the land)?
  • Have any of these already been paid?

With these questions answered, the lender can calculate your Loan to Cost Ratio. This number will show the lender how much equity you have in the project when the loan is ready to fund. It is calculated by adding up ALL of your costs for the project and dividing that number into the loan amount requested. In the ‘good old days,’ many lenders ignored this ratio. Not anymore! Today, most lenders have realized that the Loan to Cost Ratio is as important if not more so than the Loan to Value Ratio.

The loan to value is in part determined by the appraisal done on your project. I strongly recommend that you refrain from ordering any appraisal by yourself. Institutional lenders are prohibited from using an appraisal ordered by their client. Wait for the lender to order the appraisal when it is needed.

You will need to supply the lender with a complete set of building plans, a set of specifications and a cost breakdown. These will be sent to an approved appraiser who will mentally construct your project based upon your plans, specifications and cost breakdown.  The appraiser then goes out and analyzes your site and your neighborhood. The appraiser will then analyze data in the MLS to determine valuations in your neighborhood.

With all that information, he or she will then be able to give a valuation to your project which will basically be “if this house was built on this lot, with these plans, costs and specifications, and it was completed TODAY, it would be worth $XXX amount of dollars. It is not what the house will be worth in 6, 9 or 12 months when it is actually complete. The valuation is provided as if the house is done today, in today’s market. By taking that appraised valuation number and dividing it into your loan amount number you (your lender) can arrive at a Loan to Value Ratio.

If you have any more questions about the process, call us at 1-800-688-2494 today.

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