FINANCING YOUR DREAM HOME
Construction Loans Pay For Homebuilding, But Approval, Appraisal and Disbursement Processes Are Very Different From A Traditional Mortgage
Construction loans differ from typical home loans. With a traditional home loan, you make a down payment, take possession of the home, and then make a payment to the lender each month. With a construction loan, you are asking the bank to estimate the value of something that does not yet exist—and then lend you money for it. A lot can happen during the typical 12-month construction process—from the expected construction delays and cost overruns to the unexpected—like a change in your employment situation or your builder going out of business. The risk to the bank is much greater, so it exercises greater caution in loan decisions.
Financing your new dream home is an important step in the new home process. You really need to get started as soon as you can in talking with lenders, because the loan approval process is time consuming. And if you’re planning on building or buying soon, you’ll want to get a jump on it. You should get prequalified early on in the process, so you know what you’re dealing with from a financial perspective.
Understanding Mortgages
Almost every new home buyer will need to obtain a mortgage. A mortgage is a loan that is made primarily for the purpose of purchasing a home. There are two components of a mortgage: the principal amount and the interest on the principal. The principal is the actual amount of money that the lending organization lends to the borrower. The interest is the money or fee that the lender charges for the loan. The amount of interest that is paid depends on the type of loan obtained and the loan’s pre-negotiated rate of interest.
There is the standard-type mortgage that offers an amortization period of three hundred and sixty months (thirty years) and has a fixed rate of interest. And there are many more complex types of mortgages, with different interest rates, down payment requirements, amortization periods, and various other terms and conditions.
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Competitive Business
The mortgage industry is a competitive business. There are many places a borrower can go to obtain a loan, including (oftentimes) the home builder, and especially with production builders. Before shopping for a mortgage, however, the borrower should take some time to research the options. At a minimum, the borrower should have a basic understanding of mortgage terminology, lending requirements, and should know the current interest rate for mortgages. This will help the borrower develop an idea as to his or her particular mortgage needs. Then, the informed borrower should begin shopping around and comparing prices and options.
Individual lenders can assist the borrower in many ways, too. Just remember that the lender most likely will take into consideration the best interests of the mortgage company and not necessarily your own. And remember that, as a qualified borrower, you have more opportunity to negotiate the terms of the mortgage. If you’re not happy with the mortgage options presented by one lender, then move on to the next. Keep up the search until you are satisfied with a mortgage option. A mortgage is something you as the borrower will have to live with for some time, so the loan should meet your needs. And most important of all, make sure that the documents you sign contain the same terms and conditions that were negotiated beforehand. Once you sign loan documents, you are committed.
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Other Important Considerations
There are some other things to keep in mind about mortgages. First, the more money you borrow, the more interest you will have to pay. In a low interest rate environment, many people find that they can qualify to borrow more than they expected, which enables them to look at and purchase more expensive homes. This is great as long as the borrower remembers that, in the end, the home will cost more because the borrower will be paying more interest.
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Another important component of a loan is the amount of down payment. The down payment is the amount of cash that the home buyer will put towards the home purchase. Again, different loans require different amounts of down payment. Some loans require a down payment equal to twenty percent of the purchase price while other loans require no money down. Make sure you work the numbers because a larger down payment amount does not always translate to a significant savings in the monthly mortgage payment. You might find that you are better off making a minimum down payment and using any extra cash for some other type of investment or purchase.
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Loans for Construction
It doesn’t matter how many mortgages you’ve applied for, a construction loan is in many ways different than a mortgage. About the only thing these two funding sources have in common is an application. Banks structure them differently, have different approval guidelines and dispense funds differently.
Two Types Of New Construction Home Loans
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Construction Loan, also known as a ‘Double-Close’ loan. Is a short term loan which does not automatically convert to permanent financing. The drawback to this is when construction is complete, you must pay another set of closing costs. And interest rates could be higher at that time.
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Construction-To-Permanent Loan, also known as a ‘Single-Close’ loan. This type of loan gives you money to buy the land and build the house. As the house is completed, the loan rolls into permanent financing. The construction-to-permanent loan is a multiple advance loan.
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Double-Close Construction Loan
With this process you’re required to apply and get approved for two loans; a short-term loan to cover the costs associated with construction and after construction is finished, a mortgage. Besides costing twice the amount in terms of time and money (because you have to undergo two loan application/approval processes), this process is very risky. You have no way of knowing how the economy or your financial situation will change during the time it takes to complete your new home.
Single-Close Construction Loan
Anyone who can qualify should definitely opt for the Single-Close construction loan process, in my opinion. Also known as construction-to-permanent, construction/ permanent, all-in-one or one-time-close, these loans came into being as banks began to realize the profitability of securing longer-term customers. Studies showed that homeowners who actually constructed their own homes lived in those same homes longer and defaulted on those homes less often.
Some of the benefits of single-close loans include:
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The ability to roll into a permanent loan without having to re-qualify or re-appraise.
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A wide assortment of permanent loan options which makes it easier to find an option that fits your needs.
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While preparing documentation, borrowers sometimes have the option to roll the cost of buying land into the loan.
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An opportunity to lock in more favorable interest rates while still in the midst of construction.
If this is your first time building a home, definitely check into the single-close construction loan process. The process is so much easier, and the flexibility practically guarantees a loan you truly can afford.
How to Choose Your Construction Lender
When you finally start looking for lenders, you’ll notice that not all lenders offer construction loans. Take the time to interview prospective lenders. A good loan officer will listen closely to your needs and then try and match a loan product to suit those needs.
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Initiating the Loan Process
Here’s what most lenders require to process a construction loan application, which may varies from lender to lender and the builder supplies much of the documentation needed:
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A complete set of final plans;
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A detailed specifications list;
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A copy of the contract with your builder;
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Contract to purchase lot or evidence of title for property;
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A completed loan application;
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Copies of your federal tax returns complete with all schedules and W-2s for the last two years;
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Copies of your last two pay stubs;
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Copies of your two most recent bank statements.
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Cost To Complete, That Is, Your New Home Construction Budget:
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Land — If you are buying land or if you own a building lot you need to consider the purchase price or land payoff costs in your new construction budget. Land improvements like water, sewer, grading, and utilities should be included in your construction budget.
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Soft Costs — You will need home plans, site plans, permits, engineering, and other soft cost items. These expenses are often overlooked as part of the construction budget, as you will probably have to pay for them prior to closing on your construction loan. Construction lenders will want to verify that your house plans are complete and have been approved by your local building department.
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Hard Costs - These are the typical costs used in per square foot cost breakdowns, and they include site work, excavation, building materials, labor, and general contractor fees. Your contractor may give you a fixed price contract for these items. Homeowners and builders tend to focus only on these costs when they are developing their budgets, mistakenly overlooking the soft costs and land development expenses.
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Reserves — Most construction lending programs require you to have a reserve fund. Your contingency fund should be 5 to 10 percent of your total hard and soft costs. This amount should be added to your final construction budget, to be used for unplanned cost overruns. The contingency fund gives both you and the lender some security for unforeseen expenses. Many lenders also want an interest or cash reserve. The cash reserve can vary, but most programs will require you to have at least an additional six months of principle and interest payments in cash reserves.
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Loan Closing Costs — Every loan will have fees that will be charged to the borrower: appraisal fees, title fees, underwriting fees, origination fees (points), and construction loan administration fees, to name a few. The lender will produce a Good Faith Estimate (GFE) to disclose all the fees and costs to you. They can add up to as much as 3-4 percent of the loan amount.
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Construction Draws, Schedules and Periodic Advances
The construction loan funding process is unique when compared to other loan types. Purchase money loans for existing homes and loans for buying lots and land simply are funded in full at a loan closing. In contrast, a construction loan borrower receives periodic loan advances – also known as “draws” – based on predesignated milestones being met in the construction of the home.
To plan for these periodic loan advances the borrower and its contractor will work with the lender up front to establish an approved draw schedule for the work. The loan draws will be funded when construction milestones have been met and will be used to pay the builder, subcontractors and suppliers what they are owed. Milestones and methods for scheduling draws can vary from lender to lender.
To initiate the funding of a draw under your construction loan, your builder will provide a draw request form and other documents to the lender that includes a report on progress and details for the requested funds. Job site inspections will be performed and reported back to the lender to confirm the amount of work that has been completed and that the work was done in a manner that meets the job’s specifications. The inspector will be an independent party, and in some cases may be an engineer or architect. This process may seem like a lot of work, but it allows the lender to confirm that it is protected and that it is not funding more than the value of the partially-constructed home.
The first draw under a construction loan typically will cover closing costs and the purchase price of your lot. Sometimes soft costs like house plan design fees, engineering costs and permits will be included in this first draw. The timing of subsequent draws can vary widely, but they may be triggered by a time period (like monthly), by the completion of construction phases (after grading and foundation work, then after framing and roofing, etc.) or on a calculation of the percentage of work that has been finished by the contractor for the overall project. The builder will need to show that the home has been completed to process the final draw, which usually can be done with a certificate of occupancy (or its equivalent) and final inspection by the lender.
Advances under a construction loan usually are not made directly to the borrower. Instead, the lender typically will fund the draws directly to the builder or others that need to be paid.