Construction loan definitions - loan to value versus loan to cost

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As I've said in other articles on the topic of financing, getting a construction loan to build a house on your land might be the most intimidating part of building. And it's certainly one of the most confusing. Some lenders love to use industry jargon, which makes it even worse. I've been in the building industry for 18 years, and I still hear terms I hadn't heard before.

When it comes to construction loans, the difference between loan to value and loan to cost is important. Let's look at the difference and how it affects your construction loan.

I'm going to use the term "bank" rather than "lender" from here on, since that's the place you're going to get a construction loan. The banker is going to lend you a specific amount of money to build your home. That loan will provide just enough money to build while minimizing the risk to the bank.

Make no mistake, the bank's first concern is their own money despite what they tell you about their awesome customer service and so forth. The bank has to be sure they don't loan you more money than the house will be worth. To do that, they hire an appraiser who analyzes the market and gives a professional, unbiased opinion of the value of the house you're proposing to build.

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With that value established, the bank will lend you no more than a specified percentage of that number. In most cases, it's 80 percent. So, the loan they'll make you is 80% of the value of the finished home. They call that a loan to value or LTV of 80%.

But be careful because sometimes the banker will simply talk about loan to value (or LTV) when they really mean loan to cost. Let's say you're going to build a $200,000 house, but it appraises for $220,000. Since 80% of the appraised value is $176,000, that's what the banker will lend you, right? Not necessarily. It's important to ask any potential bankers up front what they will do if the appraised value is higher than the cost.

When the cost to build is less than the appraised value, some bankers will only loan you 80% of the cost. If a bank says that's their policy, you just ruled out that banker unless you have another compelling reason to use them. That being said, if the cost and appraised value are dramatically different, no banker is going to loan you more than the actual cost to build the house. At least not if they want to stay in business.

What you're looking for is maximum flexibility in your construction loan so you don't have to bring a lot of cash to the table. Loan to value is an important term to understand when setting up your construction loan, so be sure to ask the right questions up front. Then consider loan to value along with easy-to-compare interest rates and other factors when deciding which banker and construction loan is right for you.

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