IN THIS ARTICLE
One-Time-Close Construction Loans
Two-Time-Close Construction Loans
Construction Loan Details
Finding the Right Lender
Applying for a Construction Loan
Financing for Owner-Builders
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Unless you are paying cash for your project, you will need a construction loan to pay for the materials and labor, and you can use it to buy the land as well. Construction loans are a bit more complicated than conventional mortgage loans because you are borrowing money for a short term for a building that doesn’t yet exist. They are essentially a line of credit, like a credit card, but with the bank controlling when money is borrowed and released to the contractor.
Both you and your contractor must be approved for the loan. The bank wants to know that you can afford the loan with enough cash left over to complete the house, and that the contractor has the financial strength and skills to get the house built on time and on budget.
If you are converting the construction loan to a mortgage when the building is completed, the bank also wants to know that the finished building plus land will have a high enough appraised value to support the mortgage. Because the lender needs to know the story behind the project, and believe that you can make it happen, construction loans are sometimes referred to as “story loans.” There are many variations on these types of loans from lender to lender, and they change frequently, so you should talk to a few different lenders to see what plan is best for you.
Construction loans are harder to find than conventional mortgages. Start with your local bank where you already have a relationship. Also speak with other local banks including community banks, credit unions, and cooperative banks that are more likely to make these types of loans.
Owner-builders face additional obstacles since you will need to convince the bank that you have the necessary knowledge and skills to get the job done on time and on budget.
Two types of construction loans. The two basic types of construction loans used by homeowners are one-time-close loans, and two-time-close loans. In all construction loans, money is disbursed by the lender based on a pre-established draw schedule, so much money upon completion of the foundation, so much upon completion of the rough frame, and so on. The goal is to only pay for what has been completed, minus retainage, typically 10% of the cost of the project, which is held back until everything is completed properly and the owner is issued a certificate of occupancy (CO).
During the construction phase, payments are interest-only and start out small as you only pay on funds that have been disbursed. When construction is complete, you pay a large balloon payment for the full amount owed. On some loans, no payments are due until the house is completed. Fees on construction loans are typically higher than on mortgages because the risks are greater and banks need to do more work managing the disbursement of funds as work progresses. The faster the work is completed, the less you will pay in interest.
These are the most popular type of construction loan for consumers, but are now difficult to find in some areas. Also called “all-in-one loans” or “construction-to-permanent loans”, these wrap the construction loan and the mortgage on the completed project into a single loan. These loans are best when you have a clear handle on the design, costs, and schedule as the terms are not easy to modify.
The loan has one approval process, and one closing, simplifying the process and reducing the closing costs. Within this basic structure, there are several variations. Many charge a higher rate for the construction loan than the permanent financing. Typically, the borrower can choose from the portfolio of mortgages offered by the lender such as 30-year-fixed, or various ARM’s (adjustable rate mortgages). Some banks will let you lock in a fixed rate with a “float-down” option allowing you to get a lower rate if rates have fallen, for a fee of course. There may be penalties if the construction phase of the loan exceeds 12 months.
Paying a slightly higher rate on the construction phase of the loan is usually not significant, since the loan is short-term. For example, paying a extra 0.5 percent on a $200,000 construction loan over six months, would only add no more than $250 to your borrowing costs.
Construction loans are typically interest-only and you will pay only on the money that has been disbursed. So your loan payments grow as progress is made and more money is released. When the home is completed, the total amount borrowed during the construction loan automatically converts to a permanent mortgage. If you locked in a fixed mortgage rate at closing, but rates have since fallen, you can lower your mortgage rate by paying a fee – if your loan has a float-down option, a feature you will probably want on a fixed rate loan. If you had chosen a variable rate, pegged to the prime or another benchmark, then you will have to pay the current rate at the time the mortgage converts.
If interest rates are stable or rising, locking in the rate at closing makes sense. If rates are falling, a floating rate would be better – at least in the short run. If you have no idea which way rates are headed, a locked rate with a float-down provision may be your best bet.
Pros of one-time-close construction loans:
- You pay just one set of closing costs.
- You are approved at the same time for both construction and permanent financing.
- Multiple options for permanent financing give you flexibility.
Cons of one-time-close construction loans:
- If you spend more than the construction mortgage, you may need to take out a second loan, and pay additional closing costs.
- Permanent rates may be a little higher than with a two-time-close loan.
A two-time-close loan is actually two separate loans – a short-term loan for the construction phase, and then a separate permanent mortgage loan on the completed project. Essentially, you are refinancing when the building is complete and need to get approved and pay closing costs all over again. During the construction phase, you will pay only interest on the money that has been paid out, so your payments will be small, but increase as more money is disbursed. There may be a maximum duration for the loan, such as 12-month, after which penalties kick in.
The bank will typically add a 5-10% contingency amount for cost overruns, an all-too-common occurrence on home construction projects. In any event, it’s best to qualify for the highest amount possible. Think of it as a line of credit that is nice to have in place in case you need it.
Because of two loan settlements, closing costs will be greater for this type of loan. However, you may get a better rate on the permanent mortgage as you will be working with mortgage refinance rates, which are typically more competitive than the rates offered in one-time-close loans. While it is easiest to stick with the same lender for the permanent financing, in most cases you will be free to shop around to make sure you are getting the best rate and terms. Also, you will not be locked into a fixed loan amount, and will be able to borrow more if you have added upgrades to the project and increased its value (assuming you qualify for the larger loan).
Pros of a two-time-close loan
- Greater flexibility to modify the plans and increase loan amount during project.
- Mortgage rates are often lower than in one-time-close loans.
- You are usually free to shop around for permanent financing.
Cons of a two-time-close loan
- You need to be approved twice and pay closing costs twice.
- You face risks if your financial circumstances change when you apply for permanent financing.
- If you don’t get approved for permanent financing, you could face foreclosure.
Construction loans are essentially a short-term line of credit extended to you to get your house built. If you don’t use all the money, you only pay interest for the money borrowed. If you’ll be taking out a construction loan, your total loan expense needs to cover both hard and soft costs. A typical breakdown is shown below:
|Typical Construction Loan Breakdown|
|Hard Construction Costs||$250,000|
|Soft Costs: Plans, permits, fees||$20,000|
|Closing Costs: Loan fees, title, escrow, inspections, appraisal, etc.||$4,500|
|Contingency Reserve(5% of hard costs)||$12,500|
|Total Project Cost||$395,000|
|Appraised Value(completed project)||$475,000|
Owner’s equity. With construction loans, banks want the borrower to have some “skin in the game” in the form of owner’s equity. If you are borrowing on the land as well as the construction, you will need to make a substantial down payment of 20% to 25% of the completed value of the land and building. The land is typically assumed to account for 25% to 33% of the value of the completed project. If you already own the land, you will have an easier time getting a construction loan. The land will count as equity in the project, and you may be able to borrow up to 100% of the construction cost.
Land and Construction Loans. These are harder to obtain than construction-only loans, especially for vacant land vs. a developed lot in a subdivision. Construction loans are also complicated if you are buying the land from one person and contracting with another to build the house. Unless you have detailed plans and a contractor ready to go, you will need time to finalize your plans and line up a builder.
To protect yourself, it’s best to make any offer to buy land contingent on getting your construction financing approved. Also build enough time into your offer to apply for a construction loan and get approved. The more planning you do ahead of time, the better.
Some land and construction loans allow you to wait months or years before building. In the meantime, you will make monthly principal-plus-interest payments on the land portion of the loan. Check with your loan office to see what options are available.
Contingency provision. Since many projects exceed the loan amount, loans often have a built-in contingency of 5% to 10% over the estimated cost. To access this money, you may need documentation in the form of a change order, describing the additional work or more expensive materials chosen and the resulting upcharge. Some banks, however, will not pay for changes with or without a change order.
Interest reserve. Another peculiarity of construction loans is that most people make no payments at all during the construction phase. Assuming that you don’t have extra cash in your pocket during construction, most loans include an “interest reserve,” which is money lent to you to make the interest payments. The money is stored in an escrow account and paid back to the bank as interest. The interest is considered part of the cost of construction by your contractor, or by you as an owner-builder. The benefit is that you don’t have to come up with additional cash during the construction phase. The downside is that you are borrowing additional money.
Draw schedule. In general, the lender does not want to disburse more money than the value of the completed work. Nor do you if you are hiring a general contractor. If the contractor has completed $50,000 worth of work and has been paid $75,000, neither you or the bank are likely to recoup the difference if the builder leaves town, goes bankrupt, or does not complete the job for whatever reason. For that reason, you and the bank will need to establish a draw schedule based on the value of each phase of the work, called a schedule of values.
If the loan is paying for both the land and construction, then the first draw will be to pay off the land and closing costs. It may also cover costs such as house design, permitting, site development.
If you are not borrowing money, you will still need to establish a draw schedule with your contractor so that you don’t get ahead of the work completed. It’s not your job to play banker and provide your contractor with working capital or extra spending money. However, it’s reasonable for the contractor to ask for money to cover the deposit on special-order items. If you are putting up a lot of money, it’s best to put the material orders in your name. If anything goes wrong along the way, at least you’ll own the 20 high-end windows you’ve paid for.
Insurance. You construction loan will also require that you or your contractor carry General Liability Insurance, covering any harm to people (non-workers) or property caused during the construction process, and Builders Risk insurance, which covers damage to the unfinished building. The loan — and the law – will also require that your contractor carry Worker’s Comp Insurance if he has any employees. If the contractor does not carry the proper insurance, then you, the owner, can be sued by an injured employee or neighbor whose child is hurt while playing in the unfinished home. You should also ask the contractor list you and your family as “additional insured” on his liability policy.
Typically, the homeowner buys the Builder’s Risk policy, which may convert to homeowner’s insurance when the building is complete. In a renovation, your homeowner’s policy may already include this coverage, or it can be added as a rider. If your builder does not carry liability insurance, you will need to purchase this on your own before closing on a loan. Don’t hesitate to ask the contractor why he does not carry full insurance, and reconsider whether this is the person you want to build or remodel your home. You may find it easier to get a loan (and sleep at night) with a fully insured contractor. Talk to your insurance agent about your potential liability and how to protect yourself before getting too far along.
Most construction loans are issue by banks, not mortgage companies, as the loans are typically held by the bank until the building is complete. Since construction loans are more complicated and variable than mortgages, you will want to work with a lender experienced in these loans. And given that not all banks offer all types of construction loans, you should talk to at least a few different banks to see what is available in your community.
You can learn a lot by listening to the lenders’ policies on draw schedules, inspection and payment procedures, and qualification rules, which will vary from bank to bank. Also banks can be a big help in creating a realistic budget for your project – the biggest challenge for most homeowners (as well as many contractors). Following the bank’s budgeting format can help you with cost control and can also help you obtain a loan from that bank.
Some banks use loan officers employed by the bank, while others work primarily with independent loan officers. In either case, you want a loan officer experienced in construction loans and one who will walk you through the process and protect your best interests.
In most case the loan officers get paid on commission when they release funds. So there is a potential conflict of interest if the loan officer wants to release funds at the end of project and you want the funds withheld until problems are corrected. Even though payments are generally based on physical inspections of the work done, the inspectors are simply looking to see if the work has been completed, not at its quality.
Also different lenders have different policies around construction loans. For example, if you have a mortgage on your current home that you are selling, some lenders will not count that against your borrowing limits. Otherwise you may need to sell your first house before you can obtain a construction mortgage to build your new home.
Different lenders will also offer different rates. Naturally you will also want the best rates and terms available. If the bank you have dealt with for many years is a little higher than a bank you have less confidence in, tell your local bank you’d like to work with them – but can they do a little better on the rate to match their competitor. Since all banks borrow their money at the same rate, they can all lend at the same rate.
Before getting too far ahead with your plans to buy land and build, or to undertake a major remodeling project, it makes sense to find out how much you can borrow. Conversely, once you know your borrowing limits, you can tailor your design to your budget realities. You can meet with a loan officer to just gather information, or to get pre-approved if you plan to start the project soon. Pre-approvals typically last for 30 to 90 days, depending on the lender.
Pre-approval requires a full loan application and is generally valid as long as the property appraises properly and you haven’t lost your job before the loan closes. A quicker process is called pre-qualification. This is generally free and quick (1-3 days) and relies primarily on unconfirmed information you provide about your finances. Although it is not a guarantee that you will be approved, pre-qualification can help you come up with a realistic budget for your project.
Otherwise, you can waste a lot of time and money designing your dream project, only to find that it is not even in the ball park of what you can afford. And once you are in the ballpark, you will still need to make a number of trade-offs during the design process to keep within the budget (9-ft. ceilings vs. better windows, jetted tub vs. tile floor; etc.). Knowing what you can afford will help you make better decisions. You may decide that you want to add inexpensive unfinished space now, such as attic or basement, that you can finish later when you’re a little more flush.
The specific requirements to obtain a loan change from time to time and vary among lenders. but all lenders look at the same three factors: your credit score (FICO), your income-to-debt ratio, and how much equity you will be putting into the project. The higher your credit score and down payment the better your chances are for approval. If you already own the land, you’re in pretty good shape given the high cost of land these days relative to construction costs.
Income-to-debt ratio. The income-to-debt ratio limits how much of your monthly income you can use to pay off debts. Banks look at two numbers: the “front ratio” is the percentage of your monthly gross income (pre-tax) used to pay your monthly debts. The “back ratio” is the same thing but includes your consumer debt. This is expressed as 33/38, typical bank requirements for the front and back ratios. FHA accepts up to 29/41 for front and back ratios, while the VA accepts a 41 back ratio, but has no guideline for the front ratio.
Equity. Except in the bad old days of the nothing-down, “no-doc” mortgages that helped spawn the financial collapse of 2008, lenders want the borrower to have some “skin in the game.” The more money you have in a project, the less likely you are to default or not complete the project. On construction loans, most lenders today will only loan you 75% of the appraised value of the home, based on the plans and specs. This is called the “Subject to Completion Appraisal,” done by the bank. If you already own the land, you will probably have no problem with this equity contribution, since land costs have risen much faster than construction costs in most areas and usually account for a large share of the total project cost.
If you’ve been pre-approved, the building appraises within the lending limits, and you show up with full documentation and a reputable contractor, you should have no problem obtaining the loan. If you are an owner-builder, you will have the additional task of convincing the lender that you can get the project completed on time and on budget. The more cost documentation you bring the better since cost overruns (or underestimates) are the number-one problem with inexperienced builders. Hiring a construction manager may help you put together a credible package and secure the loan.
To apply for a loan, you’ll need the following, in addition to the standard financial information required for any bank loan:
- Building lot details: a deed or offer to purchase, documentation of protective covenants and other deed restrictions
- A clear description of responsibilities of the architect (if any), and the general contractor, construction manager, or yourself if you are an owner-builder.
- The builder’s resume, insurance certificates, and credit and banking references
- Complete set of blueprints and specifications
- Material’s list in the bank’s format
- Line-item budget (schedule of values) in the bank’s format
- A draw schedule (payment schedule) consistent with the lender’s disbursement procedures.
- A signed construction contract, including start and completion dates, and provisions for change orders
It is often difficult for owner builders to get construction loans. Since you are being loaned money for something that does not yet exist, you need to convince the bank that can get the job done on time and on budget. They key to this is approaching the bank the same way a contractor would – with professional plans and specs, a detailed estimate, and a proposed construction schedule. You may consider hiring a construction manager, estimator, or other building consultant to help put your package together.
An accurate estimate is essential, since the bank will assign an appraiser to determine the value of your project. If it looks like your estimate is overly optimistic and the bank does not think you can really get the project built for the loan amount, you will either need to borrow more (if you qualify), add more cash to the deal, or scale back elements of the design.
Many building projects come in over budget, and it’s the rare job that comes in under. An owner-builder’s (or inexperienced contractor’s) lack of experience can often lead to important items being overlooked in the estimate. Or the project may incur extra costs through design or construction errors, inefficiency, hidden problems, or changes to the plans or specs during the project. A bank wants protection against these uncertainties, so they may want more of your cash in the project as well as evidence that you are well-organized and have done thorough planning in the plans, specs, and budgets. Of course, you don’t want to be surprised any more than the bank does, so make sure you do your homework. Have the house completely designed, built, and paid for on paper before you start borrowing and digging.