Construction Loans
01. Three Steps
When discussing financing or refinancing real property, we usually mean the purchase of an existing home or buying a new home from a contractor. But what if you want to build your dream home from the ground up? How will you pay for it?
From a financial point of view, the process has three steps:
- Buying the Land
When it comes to bare land, lenders are usually very cautious. Raw land may be spacious, scenic, and in a great location, but it can be extremely difficult to resell in the event of default. Therefore, lenders tend to shy away from bare land financing. If they do loan money, they look for a large down payment; 20 percent with high interest or 50 percent down and 2 to 3 percent over current prime. - Purchasing bare land to build on has become a very complicated process. If an endangered species inhabits your property, construction permits may be denied. If previous owners have polluted the land, the new owners may be liable for any required clean-up costs. If you need to demolish a dilapidated building that someone considers "historic", it can be a real struggle. Other issues may include zoning laws, drainage tests, deed restrictions and property liens.
- The result of so many obstacles is that buying land is not something you should rush into. You may need help from experienced brokers and attorneys, and you'll need to get through a lengthy list of issues to help identify a suitable property. Once you find the right location, you have to find a friendly lender unless you're willing to pay all cash. Paying cash might be possible, just remember that it's tough to get cash out of raw land once it is acquired.
- Building the Home
After you obtain a suitable piece of property the next step is to secure construction financing. Lenders will want you to have blueprints and specifications, a licensed and bonded contractor and the appropriate permits in your possession. - However, with construction financing you won't just get a big check at settlement. Instead, the lender will release construction money as the project is completed. To make sure that each phase of construction is properly completed, the lender will physically inspect the project. Consequently, construction financing is more expensive than regular mortgages because it involves more work and greater costs for inspections, reviews, and disbursements.
- Permanent Financing
When the building process is over, the construction financing ends, which means that the loan must be paid off. This is usually accomplished by refinancing with a permanent loan in the same way that any real estate is refinanced.- However, lurking within the three-stage process above is a serious problem. If we've got three loans, we also have three closings. And three separate closings can get really expensive with loan charges, settlement costs, legal fees and taxes. Instead of having three loans we would rather have two or, even better, just one. The demand for this type of all-in-one loan has led to the creation of combination financing.
02. Combination Financing
One approach is to obtain the land and then use the equity in the land as the down payment for a construction-to-permanent loan. This mortgage is used to build the home and then it automatically converts to a long-term 15 or 30-year loan. This scenario involves two closings; one for obtaining the property and one for the final financing.
However, the best approach is simply to have one loan and one closing. In this case, the lender considers the land, the contractor and all the other elements needed to complete the project and then grants a loan based on the final cost. The down payment is usually 10 to 20 percent.
Another big advantage to combination financing is that the interest rates are more similar to residential mortgage costs rather than construction financing, which is usually more expensive.
03. Frequently Asked Questions
- What if I want to build the house myself?
Lenders aren't crazy about owner-builders, especially those without a lot of construction experience. Building a house shouldn't be a weekend hobby. - I paid cash for an empty lot last year. Is it possible
to use my equity in the lot as a partial down payment?
Maybe. Under many loan programs, if a lot has been owned for less than two years, the lender determines its value based on the acquisition price or a current appraisal, whichever is less. - Would it be a problem to build a small house on a big piece
of property?
Probably. Most loan programs limit the value of the bare land to about 30 percent of the final value of the property with completed improvements. - My lender has offered me a 3-month construction loan. Is
this enough time to build a house?
Could be, but what if it isn't? Small wood homes can go from foundation to escrow closing in less than three weeks, but this is rare. Before signing this loan, talk with some contractors to see what's reasonable. Remember that bad weather, permit problems, inspection delays and other issues can seriously postpone work schedules. - I've been offered a construction loan with a lower interest
rate if I pay points up front. Should I consider this option?
Probably not, but do the math anyway. Construction loans are short-term financing, so points paid in advance are usually a waste of money. - What types of insurance will I need? What if a worker gets
hurt or the contractor goes bankrupt?
Speak with your lender. Be sure to ask about workman's compensation insurance, completion bonds and liability coverage. - What if the builder does a lousy job?
The building inspectors should catch items not up to code. Even so, it's a good idea to hire a private home inspector to keep an eye on the construction progress. Inspectors can check the house once the foundation is in place, when the framing is done, and finally, when the home is completed.