A home construction loan might be for you if the current residential market isn’t meeting your needs. Building your own home beginning with the site selection up to a home customized to your wants and needs can be a wonderful experience enabling you to live in your dream home. However, it is also a time consuming process with few similarities in common with a Realtor® broker deal leading to a conventional mortgage.
It’s important to understand how residential construction loans work before you apply. To start with, there are generally two loan types available. A construction loan is a short-term loan, usually for between 6 and 12 months. The construction loan becomes due in full when the certificate of occupancy is issued. Assuming you won’t be paying off the loan in cash, you’ll need a conventional loan to replace it. Here are the key tips to negotiating the home construction loan process.
Tip #1. Find a reputable contractor. There are at least three things you’ll need before approaching a lender for a home construction loan. You need land to build on, a contractor, and building plans. Unless you have your heart set on a specific water or view building site, it’s often wise to pick your contractor first. You’ll want an established contractor known for cost containment and for staying on schedule. Two of the most trustworthy recommendation sources come from local lenders (before applying for a loan) and the BBB.
Then ask plenty of detailed questions during the interview process. Ask to see licenses. Make sure the general contractor and all subcontractors have workers comp insurance and are bonded. Otherwise, you take on unnecessary risk. Ask for references and call these people to learn how pleased they were with the construction process and the home they now live in. Involving the contractor with the building site selection helps contain costs. The slope of the land, size of the plot, zoning requirements, and access to utilities all impact the overall cost and schedule of the project.
Tip #2. A home construction loan is not secured the same as a mortgage. Lenders are more leery of home construction loans for many reasons. Most importantly because the loan is based on a home that doesn’t yet exist and a value that won’t be known for sure until construction is complete.
Improving your chances of being approved means providing as many details as possible. At a minimum, you need floor plans and details about the materials that are going to be used in the home. Everything from ceiling heights to the type of home insulation to be used. You’re also going to need an estimated appraisal based on the house specifications, the value of the land, and comparison values of other (custom?) houses in the area. You’ll need a lender experienced with home construction loans that understands the estimated appraisal process.
Tip #3. Understand how home construction loans are financed. Once you are approved for a construction loan, the bank isn’t going to hand you a check for the full amount. Your lender will issue “draws” as predetermined phases in the construction are completed. Almost always, you’ll need a 20 percent down payment towards the projected costs. Some lenders require 25 and even 30 percent down payments. They want you to have skin in the game.
The first draws issued to the contractor come from the cash you put into the deal. The contractor often receives the first 10% when the loan closes and the next 10% after the lot is cleared and the foundation is poured. The number, timing, and amount of each draw can be negotiated between you, the lender, and the contractor. It’s also common for the bank to require inspections after each phase before releasing more money to the builder.
Tip #4. Anticipate cost increases and delays. Because home construction loans are for a short term, cost increases and delays can kill your dream home project. Weather, failed inspections, material cost increases, work stoppages, and many other factors can delay the completion of your home. The full amount for borrowed funds can come due in 6 to 12 months even if you don’t have the new home to live in. Without an occupancy permit, you won’t be able to qualify for a conventional mortgage to pay off the construction loan. If your lender won’t extend the loan, you have big problems.
Make sure there is a buffer built into the construction schedule. Many lenders require a reserve fund be held back to pay for cost overruns. You will have to qualify for this part of the loan but you won’t have to pay it back with interest if it isn’t released. Still, it gives you peace of mind that the project will be completed. If your lender doesn’t hold back a reserve fund, establish one yourself.
Tip #5. Local lenders best understand the local market and have established relationships with home contractors. As a new home construction borrower, you can benefit from these relationships to smoothen and quicken the approval process. Home construction loans are typically “interest only” loans. During construction, you only pay interest on the borrowed money. Not paying down the principle lowers your payments at a time when you are likely also making monthly payments on your current home. Among the variables you want to shop for is a low interest rate that keeps you payments low. Many construction loans are adjustable loans. You may want to shop for a fixed rate loan if one is available.
Another important variable is the difference between construction-to-permanent and two-time closing loans. The construction-to-permanent loan rolls your construction loan into a conventional mortgage once the certificate of occupancy is issued. Both have advantages and disadvantages. The construction-to-permanent loan avoids paying for another closing but might come with a higher long term interest rate. Although the construction-to-permanent avoids paying for a second closing, the guaranteed financing might not cover any construction cost overages. In which case, the homeowner ends up paying these completely out of pocket.
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