Understanding Lending Ratios in Private Lending

In the world of private lending, where borrowers seek alternative financing solutions, lending ratios play a crucial role in assessing risk and making informed lending decisions.

These ratios, also known as loan-to-value (LTV) ratios, are fundamental metrics that private money lenders and hard money lenders use to evaluate the feasibility of lending to a borrower.

This article provides a detailed explanation of lending ratios, why they are essential for lenders, and an overview of different types of ratios commonly employed in private lending.

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Why Lending Ratios Matter

Lending ratios are paramount for private lenders as they provide a clear picture of the level of risk associated with a potential loan.

These ratios help lenders determine how much collateral or equity a borrower has in a property or project, allowing them to assess the likelihood of repayment and make informed lending decisions.

By using different ratios, lenders can strike a balance between providing financing opportunities and minimizing their exposure to risk.

Types of Lending Ratios

Loan-to-Value (LTV) Ratio

• The LTV ratio is one of the most common and crucial lending ratios in private lending.
• It calculates the loan amount as a percentage of the property’s appraised value or purchase price.
• A lower LTV ratio indicates lower risk for lenders, as the borrower has more equity in the property

Loan-to-After-Repair-Value (Loan-to-ARV) Ratio

• This ratio is often used in real estate lending, especially for fix-and-flip projects.
• It assesses the loan amount in relation to the anticipated post-repair value of the property.
• Lenders use this ratio to evaluate the potential return on investment (ROI) and the borrower’s ability to complete renovations.

Loan-to-Contract Ratio

• This ratio pertains to construction and development loans.
• It compares the loan amount to the total construction contract value.
• Lenders rely on this ratio to ensure that there is sufficient financing for project completion.

Debt Service Coverage Ratio (DSCR)

• DSCR measures the property’s ability to generate enough income to cover debt payments.
• It’s commonly used in commercial real estate lending to assess cash flow.
• A higher DSCR is favourable, indicating a lower risk of default for the lender.

Debt-to-Income Ratio (DTI)

• DTI assesses a borrower’s ability to manage debt payments relative to their income.
• Private lenders consider the borrower’s total debt load, including the loan being sought.
• A lower DTI is preferred, as it suggests the borrower has more capacity to repay the loan.

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Common Lending Ratios Offered by Private and Hard Money Lenders

Private money lenders and hard money lenders typically offer various lending ratios tailored to their specific lending niche.

These ratios can vary based on the lender’s risk tolerance and lending criteria. Common ratios in private lending include:

• LTV ratios ranging from 60% to 90%: These ratios determine the loan amount relative to the property’s value. Lower LTV ratios are typically offered by hard money lenders, as they mitigate risk.
• Loan-to-ARV ratios between 65% to 75%: Hard money lenders who specialize in fix-and-flip loans often use these ratios to assess renovation projects.
• DSCR requirements of 1.2 or higher: Commercial real estate lenders typically seek a DSCR that ensures sufficient cash flow to cover debt payments.

Conclusion

Lending ratios are indispensable tools in the private lending industry, helping lenders evaluate risk and make informed lending decisions.

By understanding different types of lending ratios, borrowers can better prepare their loan applications, and lenders can assess the viability of funding projects.

These ratios are vital in maintaining a delicate balance between providing financing opportunities and managing risk in the dynamic world of private lending.

Whether you’re a borrower seeking private financing or a lender considering lending options, a firm grasp of lending ratios is essential to navigate this sector successfully.

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