We craft quality with economy
FREQUENTLY ASKED QUESTIONS
ON CONSTRUCTION LOANS
Q.
What is an "All-
A.
A "single close" construction loan is also your permanent financing. It is not just
an interim construction loan, which would require a "take out" loan refinance at
the end of construction to put the permanent financing in place. This "take out"
loan would involve an additional set of closing costs, you would have to provide
new income and asset documentation to qualify, and qualification would not be guaranteed.
The best "single close" programs are usually based on a 1 Year Adjustable Rate Mortgage,
which has associated with it an aggressive offer to modify your note at the end of
construction. The note modification would be to a longer term fixed rate program
at current market rates. Being a note modification and not a refinance, there is
little or no cost, and the process is as simple as signing a few pages and sending
them back to the lender. You are not subject to re-
Q.
So how many loans and escrows do we need to build our own home?
A.
You can have as many as three, and as few as one. If you purchase the land at the same time you close a construction loan, and that construction loan is a "single close" construction loan, you can get by with just one set of closing costs, and one escrow. Three sets of closing costs would be incurred if you: 1) purchase the lot first, either paying cash or by getting a lot loan, 2) you obtain an interim construction loan when you have plans drawn and a builder lined up, and 3) you then obtain a "take out" loan to provide the permanent financing.
Q.
When can I buy the lot using a construction loan, and when do I have to first get a lot loan?
A.
If you have found a lot, and you wish to use one of the low rate "single close" construction loans to acquire that lot, you need to have a long enough "close of escrow" written into the purchase contract on the lot so that you can obtain plans and select a builder in that time period. A construction loan can only close with architectural plans, a signed contract, and a cost breakdown with a builder based on those plans. From a practical standpoint, if you enter into a contract to purchase a lot, and you haven't yet begun the process of developing plans with an architect, you're probably going to have to obtain a lot loan or pay cash for that lot. The situation where it is easiest to use a "single close" construction loan to purchase the lot is when the lot is owned by the builder, and the builder has architectural plans for that lot that suit you.
Q.
If we already own our lot, how do we determine how much we can borrow?
A.
Generally speaking, you will almost always be able to borrow a percentage of the future value of the house, regardless of how long you've owned the lot or the total costs of the build. Since new construction almost always appraises for more than total costs, this often works in your favor.
Q.
Should we pay off our lot before we apply for a construction loan?
A.
There is probably no reason to pay off your lot loan prior to the construction loan funding. If you have a lot loan, the new construction loan will pay off that lot loan just like any refinance would. The lot and the new improvements constitute only one piece of real estate, and the lot loan has to be paid off so the construction lender ends up in first lien position. If you pay the lot loan off prior to applying for a construction loan, you may be handcuffing yourself by putting too much cash into the deal. Construction loans are almost always "no cash" out loans, so it may not be possible to get this cash back on acceptable financing terms until one year after the home is complete. You are often better off having cash on hand during construction to handle upgrades and changes, especially if you are doing a loan without a contingency.
Q.
What is a contingency, and should I have one?
A.
A contingency is a line item in your cost breakdown that does not have a specific element of your build associated with it. If, during the course of construction, you decide you want some additional work done, or you decide you want to upgrade your materials (from granite tile to a slab of granite for example), you can used the money in your contingency item to do this. Without a contingency, you would have to pay "out of pocket" for these changes, since the loan amount on a construction loan cannot be increased during construction. A contingency is generally a good idea if there is room enough in your appraisal that you are not already at the maximum loan to value percentage allowed by the lender. Naturally, you also have to be able to qualify for the higher loan amount necessitated by the inclusion of a contingency. You only pay interest on the amount borrowed, so you are not charged interest on unused contingency funds. By virtue of raising your loan amount, the inclusion of a contingency will slightly increase your points and some of your title and escrow fees.
Q.
Do we need to sell our current home before building a new home?
A.
In terms of qualifying, some lenders will allow you to obtain a rent survey on your current residence, and you can use an industry standard 75% of those market rents to offset the principle, interest, taxes and insurance payments on your current residence. Other lenders will underwrite in such a way that you have to carry both payments, the one on your existing residence, and the payment on the "single close" construction loan. Consult with your lender, and they will be able to determine whether you qualify, and for which loan program. If you are already renting, your rent will be ignored by the underwriter. If you need the proceeds from the sale of your current house to close escrow on the construction loan, you'll have to sell your current residence prior to, or simultaneously with, the funding of the construction loan.
Q.
If we have to bring money into the deal, when do we have to bring it in?
A.
The answer to this question is dictated by the fact that we are talking about "single close" construction loans. There is not another close of escrow when the house is done. If you were buying a "spec" house from a builder, where the construction financing and the property were in the builder's name during construction, there would be a close of escrow at the end of construction when you purchased and took title to the property. That is not the case here. With a "single close", you already are on title, and you already have your permanent financing. If you have to bring $100,000, for example, into this deal to make it work, that $100,000 will be brought in up front at the close of escrow of this construction loan. If that $100,000 exceeds the amount of money needed to pay off the lot loan and pay closing costs, the excess money will be put in an FDIC insured, interest bearing account in your name at the lending bank, and this money will be dispersed prior to borrowed funds being used. No lender will allow you to bring in your funds later, at the end of the build for example, to finish the project. Understandably, they will worry that you will no longer have the funds, and they will end up with an unfinished house as their collateral. It is surprising how many borrowers, and even how many inexperienced loan officers, do not understand this part of construction lending when they first get involved.
Q.
Can we start construction using our own funds, and get a construction loan later when we need it?
A.
Different lenders have different rules, but most do allow work to have been started. One lender, for example, requires that less than 30% of the work be complete. All lenders require clear title, and this situation can be thought of as a title problem. To issue title insurance, title companies will require indemnification agreements to be signed by contractors and subs who have already done work. This is to protect against mechanics liens taking priority over a lenders first mortgage lien. This issue most often comes up because the builder is tired of waiting for the borrower to obtain financing, and he or she is threatening to walk. This is a good reason to use a company experienced in construction lending, and a good reason to get started early in arranging your financing. Another possible problem with starting the build "out of pocket" is that when you are applying for a construction loan, your reserves have been depleted, and your file is not as strong.
Q.
Can we use any builder?
A.
Most construction lenders will request that a builder approval questionnaire be completed
by the builder. The lender will check: "happy homeowners" for whom the builder has
completed similar projects, vendor references to insure they have substantial open
credit, and other construction lenders with whom the builder may have worked. They
will also run a credit report, checking in particular for IRS delinquencies, and
this could bring your build to a halt. The bottom line is that this builder approval
process is not only good for the lender, it is good for you. They will probably perform
a much more thorough check than you might, though any legitimate, well-
Q.
How many draws can my builder get, and where does the money go?
A.
Again, the answer depends on the lender, but most lenders have the builder propose a draw schedule. A rule of thumb is that lenders don't usually like to do draws at less than 3 week intervals, but nothing is cast in stone. If frequency of draws is a hot issue for your builder, banks can usually handle the arrangements. As to where the money is sent, it is usually wired to the builders account, or to a joint account that requires both the builder's and the borrowers' signatures, and which has been set up specifically for this project. Draws being sent to the borrowers directly is often a possibility if all parties agree in writing, and the account is a construction account and not the borrowers' personal checking account.
Q.
Can I act as my own general contractor?
A.
Owner/builder is a difficult exception, available only to someone who is themselves
a builder/remodeler, and who can themselves pass the builder approval process (see
"Can we use any builder?" question). If these criteria are met, the lender would
have to be convinced by circumstances that the builder is truly building their own
home, and not doing a "semi-
Q.
Can the interest charged for the entire construction period be paid by the construction loan?
A.
Yes. Most lenders permit an "interest reserve" account, wherein anticipated interest
for the construction period becomes part of the loan amount. In this case, the borrowers
do no get a monthly bill for interest (construction loans, except FNMA Rehab, are
interest only during the construction period). As with a contingency item, "interest
reserves" only make sense if there is "room in the appraisal", and the borrowers
are not already at the maximum allowable "loan-
Q.
Can we pay our loan balance down at the end of construction before our note is modified into a fixed rate?
A.
Yes you can. A common occurrence is that the borrowers have now sold their previous
residence, and they wish to use some of these funds to buy down the construction
loan prior to the note being modified to longer term fixed rates. Some lenders even
allow a loan to be bought down from jumbo amounts to conforming, wherein they will
then offer even lower fixed rates. A high loan-
Great Urban Myth #1 in the Construction Loan Industry.
You can get a lot loan that "rolls" into a construction loan automatically.
Debunking the Myth:
Borrowers that hope Myth #1 is true usually want two things. They want construction loan rates (which are lower than lot loan rates), and they only want to go through the loan process one time with one set of closing cost.
This all sounds good, but a problem arises because generally, borrowers who are buying
a lot do not have plans, a contract with a builder, and a cost breakdown by the time
they need to close escrow on the lot. Construction lenders will not fund an open-
Great Urban Myth #2:
I can get a construction loan to do most of the work (through drywall for example), and I'll do the finish work myself.
Debunking Myth #2:
Lenders will only do a construction loan for a complete house. You could leave such items as landscaping, a swimming pool, finishing a bonus room, a security system, and ceiling fans out of the project, if these were accounted for in the appraisal. You can not leave out the cabinets, a driveway, appliances and floor coverings (though you could put down vinyl to be ripped up later). You have to have a garage door, but not necessarily a garage door opener.
The reason for all this is that a lender's nightmare is that you stop making your payment. A lender's worst nightmare is that you have stopped making your payment and the lender has to find a builder to finish the house. This is why they'll have your builder sign a form that says if you stop making the payment and they have to foreclose (trustee sale in California), the builder will finish the house for the lender so it can be sold.
