Obtaining a construction loan to build a house on your land or lot can be an intimidating process. This is partially due to confusing construction loan jargon. So, we are going to talk about two very important terms—loan to value (LTV) and loan to cost (LTC). Understanding the difference between LTV and LTC will help as you try to find the right lender to provide your construction loan.
Construction Loan Terminology
Lender vs. Banker
Before we begin discussing construction loan terminology, let me clarify one important point. Banks provide construction loans. Because of this, I am going to use the term “banker” rather than “lender” throughout the rest of this article.
Loan to Value (LTV)
A banker is going to lend you a specific amount of money to build your custom home. The banker’s goal is to provide just enough money to build your house, while minimizing the risk to the bank. In other words, the banker must ensure that they do not loan more money than the house will be worth. To do this, they hire an appraiser to analyze the market and give a professional opinion on the value of the house you are proposing to build.
Once the appraisal is complete, the bank will lend no more than a specified percentage (normally 80%) of the appraised value. In other words, the bank will loan you 80% of the appraised value of the proposed home. This is a loan to value (LTV) of 80%.
Loan to Cost (LTC)
Take caution, however, because sometimes, the banker uses the terminology “loan to value” (LTV) when they really mean “loan to cost” (LTC). Why is the distinction between LTV and LTC so important? Well, let’s say the builder has estimated the cost of your home at $500,000. The appraisal, however, is for $525,000. Since 80% of the appraised value is $420,000, that’s what the banker will loan, right? Not necessarily. It’s quite possible the bank will only lend $400,000—the loan to cost. Thus, it is very important to ask potential bankers what they will do if the appraised value is higher than the cost. In other words, do they really utilize loan to value? Or do they actually use loan to cost?
LTV or LTC – So what?
Why is it so important that you understand what type of construction loan you are receiving? Well, when the cost to build is less than the appraised value, some bankers will only loan 80% of that cost. So, let’s say your builder estimated the cost to build at $500,000; however, it only took $480,000 to complete the house. This is awesome, right?! Yes, but…
You were expecting $400,000 from the bank (80% LTV of $500,000). Since the house only cost $480,000, the bank might only be willing to loan $384,000 (80% LTC of $480,000). That is $16,000 less than you expected to receive in loan money…
I imagine you are beginning to understand why it is so important to clarify whether the bank utilizes loan to value OR loan to cost when calculating its construction loans.
What to consider when looking for a construction loan…
Please, don’t let all this math scare you! Ultimately, you should look for maximum flexibility in a construction loan. Loan to value versus loan to cost, how much cash you will be required to bring to the table, interest rates, and draw schedules are all factors to consider when deciding which bank you would prefer to work with while building your home.
Want more information about how to choose the right lender? We’re here to help!
- Read our article, “How to find the right lender.”
- To learn more about financing, read “How to Find and Buy Land: Step 1 – Obtain Financing.”
- Contact us for a list of financial institutions that we know provide construction loans.
- Subscribe to our newsletter and receive our FREE eBook, “Building a Custom Home on Your Land: A Step-By-Step Guide.” It contains an entire chapter about obtaining construction financing for your dream home.