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 short-term for a building that does not yet exist. A construction loan is 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.
ONE-TIME-CLOSE CONSTRUCTION LOANS
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 an 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.
TWO-TIME-CLOSE CONSTRUCTION LOANS
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 the 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 LOAN DETAILS
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|
Cash Down Payments. With construction loans, banks want the borrower to have some “skin in the game” in the form of cash deposit. If you are borrowing on the land as well as the construction, you will typically need to make a substantial down payment of 20% to 30% of the completed value of the land and building. The down payment is due at closing and will be used to pay the first one or two payments to the contractor. That puts your money most at risk — that’s the way the bank likes it!
Using Land As Down Payment. 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 owner’s equity in the project, and you may be able to borrow up to 100% of the construction cost if you meet the loan criteria (credit score and debt/income ratio) and the completed project appraises well.
Construction Loans for Land. Loans for both land and construction 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, working with the contractor, will need to establish a draw schedule based on the value of each phase of the work, called a schedule of values.
Banks have different procedures for establishing the draw schedule, but there is usually some room for negotiation. Payments are typically tied to milestones in construction, such as completion of the foundation, framing, and so on.
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, and site development.
Read more on Draw Schedules
Disbursements. Before doling out money, the lender will want to make sure that the current phase of work has been completed properly, that subs and suppliers have been paid and signed lien waivers, and that the project is moving along without any serious problems. Banks typically hire independent third parties to inspect the work for completion and compliance with the specifications. However, you cannot rely on the bank’s inspection as an assurance of quality workmanship. For that, you would still need to hire your own private building inspector to make periodic inspections.
Insurance. Your 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.
FINDING THE RIGHT LENDER
Most construction loans are issued 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 cases, 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 the 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 ask if they can lower the rate to match their competitor. Since all banks borrow their money at the same rate, they can all lend at the same rate.
GETTING PRE-APPROVED or PRE-QUALIFIED
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.
APPLYING FOR A CONSTRUCTION LOAN
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
FINANCING FOR OWNER BUILDERS
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.
Will Lender Help Project Go Smoothly?
I want to pay cash for my new build, but I am concerned about the builder taking advantage of me with draw schedule, completing the house properly, closing, etc. as this is my first (and only) time I will be building. I feel like a lender would stay on top of all of this with the builder and protect me. Is this true?
If so, what are my options? Can I only get a construction loan for the duration of the build and then pay it off completely once the house is complete?
To note, my current house on my lot still has a mortgage, but i am locked in at a great rate, so I don’t have any urgency to pay this off. But for the new build, I have saved to pay it all with cash.
I appreciate your thoughts and time in answering this question.
It sounds like you are borrowing money in the hope that the bank will perform the job of a construction manager and building inspector — guaranteeing that the job will be completed on time, the work will meet quality standards, that payments will be disbursed at the right time, and you will not be overcharged.
I don’t think you can rely on a bank to perform those tasks to your satisfaction. The bank is mainly concerned about protecting their investment. Their interests overlap with yours but are not identical.
Every bank handles construction loans a little differently. In general they will only work with builders they have approved. They may and may not perform an inspection before every payment and they usually use outside inspectors, whose knowledge of construction may vary.
They will make sure that the proper insurances are in force and that the payment schedule is reasonable. And they will only disburse money when the phase of work is completed. However, they will not be concerned about the finer points of construction quality, such as sloppy drywall work, poor miter joints, etc.
Also, if there are cost overruns, you will be responsible for the extra costs through a contingency reserve required by the lender. If you feel the extra costs are not justified, you will need to resolve that with the builder.
So working with a bank will provide some level of protection, but there are probably better ways to protect your interests.
1) Choose a contractor with impeccable credentials and a stellar reputation. You may pay a little more, but the savings from going with the bargain contractor often evaporate into a haze of change orders, extra costs, and other snafus. This is the most important decision you will make in the project.
2) Make sure the contract contains language that makes final payment contingent on all work being “approved by owner in a final walkthrough” or similar language.
3) Have your contract reviewed by a real estate lawyer to make sure it adequately protects you.
4) Consider hiring an independent third-party inspector to inspect the work quality compliance with the plans at multiple points during the build. This is common in some markets, especially when working with a developer. Inspections can also be performed by the architect if one is involved.
Can We Pay Off Construction Loan When We Sell Our House?
We live in California, bought a property in Texas and want to build a custom home. Is it possible to get a construction loan, place our current home up for sale and upon sale of our current home pay off the construction loan?
If you qualify for a construction loan and come up with the down payment – typically 20% or more of the appraised value of the completed home – then paying off the loan early should not be a problem. There is generally no prepayment penalty on a construction loan, so you can pay it off as soon as your home sells.
Construction loans are for short-term financing only and need to be paid off when the house is complete. Most people pay off the construction loan by taking out (or converting to) a conventional mortgage. In your case, you can pay down some or all of the loan with the proceeds from selling your current home.
If you don’t have sufficient cash for a down payment, you may be able to borrow money on your current home, assuming you have substantial equity in the home. This is usually done through a home equity loan or home equity line-of-credit (HELOC). A HELOC is a very convenient and cost-effective way to borrow on the equity in your current home. It’s essentially like a credit card with a very high limit – up to 80% of the equity in your current home.
As with any loan, your borrowing limit will also depend on your income, credit score, and total amount of debt. You can have all the equity in the world in your current home, but your loan still needs to comply with the bank’s allowable debt-to-income ratio.
Many banks have online calculators that can give you a rough idea of your borrowing limits. Also meeting with a loan officer to get prequalified or pre-approved for a loan is a good place to start. You can also discuss your options which will vary from one bank to another, especially for construction loans and bridge financing. For construction loans, you are usually best off working with a local or regional bank or credit union. Independent mortgage brokers specializing in construction loans are another resource to tap.
Allison Knapp says
How Can I Finance Large Lot To Subdivide?
I am interested in purchasing 4.37 acres and subdividing it into 4 lots. I want to sell three of the lots and keep the last one to have a home built on. How would I go about securing financing for the land purchase? Would I have to sell the other lots before I could apply for a construction loan on the parcel I am keeping?
Some lenders offer comprehensive one-time-close construction loans that let you buy the land, build the house, and convert to a standard mortgage — all with one approval, one closing, and one set of fees. In most cases, lenders will lend up to 75% to 80% of the value of the finished home (and land), as long as you qualify for the loan amount.
To qualify, you need a good credit rating and low enough debt-to-income ratio — that is, you are not carrying too much debt. Also, your project must meet the loan-to-value ratio, meaning the finished project (house and land) must appraise high enough to support the loan amount.
In addition, the bank must be confident that your contractor you have selected is financially stable and able to deliver the project on time and on budget. It’s easiest if you work with a contractor known to the bank. Lenders do not want to get stuck with a half-built house if the project goes off the rails for any reason.
If you qualify for the loan and have the cash necessary for the down payment of 20-25%, then you can probably find construction financing without selling off any parcels. If you need to subdivide and sell off parcels to raise cash the house construction, then you will have to wait until they are sold to apply for a construction loan.
In that case, you would first need a land-only loan and apply later for a separate construction loan. In most cases, the construction loan would be used to pay off the land loan and consolidate this into a single loan.
If you were an experienced developer with a solid business plan, a bank might loan you money for the entire project based on the value of the unsold lots, but this is unlikely in your case. In general, banks are pretty conservative about construction loans. These are short-term loans, typically for less than one year, and they use the bank’s own money. Unlike mortgages, they are not resold. So banks are looking for a rock solid plan with few unknowns.
Best of luck with your project!
Out-of-State Construction Loans?
Are we able to get approved for an out-of-state construction loan based on our current jobs? We live and currently work in FL, but we want to build a house in TN. My husband is self employed and can work anywhere. I am a teacher. I’ve been teaching for 16 years. We want to avoid having to rent in TN and leave midyear at my current school. Is this possible? We have 20% down, very good credit/FICA scores, and have been employed continuously for 19 years. Thank you for your help!
Your strong financial record and 20% down payment will certainly help. Still, getting a construction loan is more difficult than a conventional mortgage for a number of reasons. In addition to proving your financial qualifications, you need to provide the bank with a credible house plan, an approved contractor, and realistic budget. Since the house that secures the loan does not yet exist, the bank is taking on additional risk that it will not be completed on time and on budget.
For that reason, banks tend to keep construction loans close to home where they know the market and the contractors. Generally, these loans are obtained through local and regional banks and credit unions. So getting a loan for an out-of-state project could be challenging. If you already own the land, that can be used as part of your down payment, and also provide the lender with added security.
If you do business with a local bank, that is usually the best place to start your research. Even if they will not take on this loan, the bank’s loan officer should be able to point you in the right direction. You can also try applying in the community where you plan to build. In either case, they will want documentation of your current and future income, assuming you will be leaving your job. Documentation of self-employment income for the past two years will also be required.
If you’re not having luck with local banks in Florida or Tennessee, you should contact an independent mortgage broker specializing in construction loans. They have access to a wider portfolio of loans and lenders and might be able to match you with an appropriate lender – possibly at a higher interest rate. Online research can also be helpful, but be wary of sites that ask for your contact information as they may share this with many lenders who may bombard you with calls. The Lenders Network seems to get positive reviews, but I have never used it personally.
Best of luck!
When Is Down Payment Due on Construction Loan?
I have own my lot free and clear since 2013. I have been working with a builder and the blueprints, soil test, and engineer have been paid for, so I have everything I need to pull permits to start building. Now I’m searching for a lender. The builder estimated the build to cost 365,000 and the land is estimated to be worth approximately 30,000. My confusion is when is the down payment due and when is the closing cost due for a construction to perm loan? I understand if I want to avoid PMI, I will need 20% approximately 70,000 plus closing cost and other fees may be about 4000-10000. The down payment is due before construction begins and closing cost is due when the home has been completed? When does the construction loan close if it is a construction to perm loan? If I will be making interest only payments during the construction loan, none of that money goes towards the perm loan? I am trying to figure out my approximate out of pocket costs and when I need to pay these costs.. Thank you for any clarity you can provide.
There are many variations of construction loans, but on construction-to-permanent financing, also called one-time-close loans, there is only one closing.
So, in general, you will have to pay all closing costs, including your down payment, when the loan closes before construction begins.
You are correct that you will need a 20% down payment, based on the market value of the home and land, to avoid PMI with most conventional loans, although FHA and other government backed loans have different rules.
In most cases, you can apply the appraised value of your lot toward your down payment, which will reduce your down payment. If the land is worth $30K and the total (house plus lot) appraises at $395K, then you would need a down payment of only $49K ($79K -$30K).
You best bet is to sit down with a loan officer at your local bank (usually the best place to start) and get answers to all your questions. Few borrowers know all the ins and outs of construction loans, so they are usually happy to answer these questions. Some banks even have a printed guide to help you navigate the process.
Best of luck with your new home!
Brian Wheeler says
Construction Loans For New Retirees?
I have a question on financing. We are planning to build on a lot we currently own, using a construction-to- permanent loan. I will be working when we initiate the project but will retire during the building. Which income do I have to qualify under — my current salary or my pension? The problem is that I won’t have an official pension number until about three months after I actually retire. I have written retirement estimates from our human resources office (I’m a federal employee), but those are not the final number that will be issued by the Office of Personnel Management.
Lenders have a lot of discretion and differing policies on construction loans, so your best bet is to check with a loan officer at the bank(s) where you plan to apply. Also FHA and other loan programs often specific requirements for income verification.
In general, lenders look at your employment history and salary for the past two years, but also evaluate your income prospects for the next one to three years. They look for job and income stability and want to know about any upcoming changes such as new jobs, layoffs, or retirement (as well as upcoming raises that you can document). The lender will typically confirm your employment and salary with your employer before closing on the loan.
The manager at my local bank told me that, in your situation, they would most likely use your new income estimate after retirement for purposes of qualification. They also consider assets with retirees, viewing these as a “reserve” than can be drawn down if needed. Assets are not counted toward income, but could tip the balance in a close call. Regular income generated by assets such as bonds, will add to your total income.
You are legally obligated to provide the lender with information about upcoming job changes. If the changes are unplanned – say, you are laid off without notice – then you are still obligated to notify the lender prior to the loan closing, and may lose the loan approval.
If you lose a job after a loan closes, then you are fine as long as you can make the payments. This is one of the big advantages of construction-to-permanent (one-time-close) loans. A lot can happen in 12 months.
Some people try to get their loan applications in while they are still employed and fail to tell the bank about upcoming changes. As a practical matter, these issues rarely come to light unless the borrower defaults. In that case, he runs the risk of a fraud charge in addition to foreclosure. The loan can also be called if the less-than-honest borrower is found out. Honesty with lenders is the best policy.
You can improve your loan prospects by paying off any car loans or other loans including credit-card debt. For construction loans, credit unions and local and regional banks are generally your best bet.
Best of luck!
Using Land As Equity for Construction Loan
I currently own property valued at $90-95k. I’m interested in financing a new home construction with the land as equity. The new home would cost $325-350k as a final mortgage. The land was purchased over 10 yrs ago. I have very limited savings to contribute to the project. Can you offer some advice and is it feasible to accomplish this build.
Many lenders will accept the deed to your land as your equity contribution to a construction loan, which typically requires a down payment of 20% to 30% of the total project appraised value – land plus completed home.
If your new home will be worth, say $350,000, when completed, then the bank will typically lend you up to 75% or 80% of that amount, or $262,000 (based on 75%).
If you can get your home built for that amount, you are in good shape. Otherwise you will need to contribute additional cash out of pocket.
Remember, however, that equity is only one piece of the process of loan qualification. You must meet all the lender’s criteria for the loan: based on your credit score and debt-to-income ratio. These factors will determine your loan limits and interest rate.
If you cannot find a local lender who will work with you, you can extend your search by finding a mortgage loan broker who specializes in construction loans.
If you are still unable to borrow the necessary amount, you will need to get creative, which is easier said than done. Save more money, borrow from relatives, build you house in stages, or otherwise match your building budget to your financial reality.
Best of luck with your project!
Janice Turner says
Bank Won’t Let Me Live On My Property During Construction
I recently purchased land on which to build a home. I have to move from where I am living now. I purchased a travel trailer to live in, on my property, while my home is being built. I was just told by the lender that I cannot live on the property while the home is being build. I am willing to sign a waiver stating I will not make any improvements to the property. I have no other place to live and used my money to purchase the travel trailer. Is there anything I can do?
I would start by asking the bank what is their specific objection to your living on the land while you home is under construction. Also ask if there is any language in your loan contract that specifically prohibits you from living on the land.
Once you identify their concern, ask what you would need to do to address the issue. Banks exercise a fair amount of discretion is their construction loan policies, so there is often room for negotiation.
If you are using the land as a down payment on a construction loan, and the bank is holding the title to the land, they may concerned about liability for harm to you or caused by you. A “hold-harmless” clause that relieves the bank of potential liability might do the trick.
You will also need to establish that living on the site in a trailer is permitted by local zoning regulations.
If the bank will not cooperate, a brief consult with an experienced real estate lawyer might be worth the expense. They may be able to help draft an addendum that addresses both the bank’s concerns and your own.
sanjay kumar says
Where to Find One-Time-Close Construction Loan?
Can you let me know which type of bank provides one-time-close construction loans? Thank you.
While most homeowners would prefer one-time-close construction loans, they are harder to find today than in the past. After the subprime mortgage crisis in 2007, banks have gotten a lot more restrictive in their lending.
Construction loans tend to be local affairs, so it is best to start your search with state and regional banks, including community and cooperative banks as well as credit unions. Start with the bank where you have an existing relationship. If you’re not having luck, try contacting a private mortgage broker in your area. Mortgage brokers work with a large number of lenders so they can often match you with the best lender for your particular needs.
Construction loans are more complicated than conventional mortgages. Banks need to be confident that you have a realistic budget, are working with a reputable contractor, and that the appraised value of the completed house will support the loan amount. So the more information you can bring to the bank on your first meeting, the better your chances of a favorable response.
Best of luck with finding a suitable lender!
Christina Compton says
Trying to Buy House We Are Living In and Renovating
We are living in the house we want to buy. The owner agreed to let us pay payments each month until we could get a good down payment together. We have started an addition on the back of the house which is now under roof. Now that we have our down payment we would like to purchase the home. Because there is new construction we haven’t been able to do so. Do any loan companies or banks offer loans when there is unfinished construction?
Some banks offer renovation loans that provide money for fixer-uppers, and include the cost of renovations in the initial loan. These loans appraise the house at its completed value, allowing for a higher loan amount than a traditional mortgage. FHA 203(K) loans and Fannie Mae’s Homestyle Renovation mortgage are two variations on this theme.
In both programs, you are able to borrow money to purchase the home, plus additional dollars to complete the renovation work. In the Fannie Mae loan, the extra money goes into an escrow account and is disbursed as work is completed. The 203(K) loans work a little differently, but the end result is the same.
In either case, you will need to find a lender who participates in one of these programs and is willing to work with you as an owner-builder, if that’s your plan. You will need to provide a lot of documentation including detailed building plans, a detailed estimate of the work to be completed, and a construction schedule. As an owner-builder, you will need to demonstrate to the bank that you understand the scope of the project and have the ability to get the work completed in a timely manner.
In most cases, you will have better luck with a local bank or credit union rather than a large national bank. If you already have a good banking relationship in the community, that’s usually the best place to start your search. If you are having difficulty finding a lender, you can also contact an independent construction loan broker, who may be able to connect you with a suitable lender.
It’s not clear from your letter, but it sounds like the seller is holding some of your rent as part of a down payment and that you have started an addition on a house you don’t yet own. Hopefully, this will all work out in the end, but it all sounds risky unless you have a clear written agreement detailing what happens to your down payment and construction work if you are unable to buy the house.
Best of luck with your home purchase!
Christina Compton says
Thank you for your input. You understood our issues perfectly. My husband is the builder,he was a contractor years ago, so we are getting started on blueprints and more insurance. Hopefully it all comes together and we can get a loan for it all.
Can Relatives Provide the Down Payment?
If a family member gives me $50,000 to purchase the land to build a house on. Would it be better if I could go and purchase the land 1st or could I do a land & construction loan combined and use this towards a down payment and only have one closing cost? Would the banks allow you to use the $50,000 as a down payment or would they not like that? I know with regular mortgages they do not like to see large sums of money being borrowed from a family member.
The main issue here is the debt-to-income ratio. If the money is gifted to you, it is yours free and clear and the bank does not really care where it came from.
However, if you are borrowing the money, you will need to disclose that to the bank and it will be counted toward your total debt. This will limit your borrowing limit whether you buy the land first or use a one-time-close construction loan. So I don’t think that really matters in terms of your borrowing limit.
The annual federal tax-free gifting limit now is $14,000. This can be legally increased to as much as $56,000 if, for example, your mother and father each give $14,000 to you and $14,000 to your spouse. Or the gifts can be made over two years – for example, you can receive $14,000 in December and $14,000 again in January. State tax laws may vary on this. Best to check with a CPA before proceeding, however, as tax laws can be pretty confusing.
Best of luck with your new home – hope you’re able to make it work.
One vs. Two Closings: Which is Better?
Hi, we have two options and not sure which would be the smartest way to go.
We can either do a loan with one closing, but can only use 50% of land value towards down payment OR we can do 100% of land value, with two closings.
Which would be the smarter and more affordable way to go?
There is no right or wrong here. There are pros and cons for each type of loan. Which is more affordable depends on interest rate trends (up or down) and your time horizon. If you plan to hold the loan for many years, then an increase in closing costs may be offset by long-term savings in interest rates.
A one-time-close loan provides a measure of security – that is, you don’t need a second approval for permanent financing. However, if your project goes over budget, these loans are hard to adjust so you may need to dig into your own savings to fund the extra charges or take out an additional loan. So one-time-close loans are best when you have clear plans and pricing – for example, a semi-custom home from a developer.
A two-time-close loan is easier to adjust mid-stream, so it may be more suitable for a custom home where some details are not fully nailed down. Also, you may pay a little less interest on a two-time-close loan – at least during the construction phase.
With a two-close loan, you won’t know the interest rate on the permanent mortgage until you apply. If you think that interest rates are likely to rise, then locking in the rate with a one-time-close loan could work to your advantage. If interest rates are stable or falling, a two-time-close loan can be cheaper over the long run. But it may take years of slightly lower monthly payments to recover the added closing costs. If you plan to stay in this home for many years, a lower interest rate has more value for you.
Some banks allow you to shop around for permanent financing, giving you additional options when it’s time to apply for your mortgage loan.
To decide which is best for you, you will need to dig into the details of both loans: especially interest rates and closing costs. Ask your bank for written estimates of closing costs for both types of loans. Compare rates and closing costs to estimate how long to recover the extra closing costs of the two-time-close loan. You’ll need to estimate the interest rate of the permanent loan.
In your case, you also need to evaluate the value of using your land as a down payment. How much cash will you need to contribute toward the one-closing loan vs. the two-closing loan? All things being equal, almost everyone would rather put less cash into the deal. How much do you need the cash for other things and how will you use it if you don’t need it for your downpayment?
The answers are never 100% clear and usually balance short-term benefits vs. long-term. For example, how much extra would you pay in “points” at closing to buy down your interest rate? Similarly, would you delay retirement for one year to get a larger monthly check? You run the numbers, make some reasonable assumptions about the future, and make your best guess.
Best of luck with your loan and new home!
Will Banks Loan to Owner-Builders?
We are planning to build a custom home next year. We own the land, its on a lake in NC. We plan to have a contractor do all of the work on the house through drywall, and then we want to finish the details through to C/O. We have about 70% of the money and need about 30% from a bank to pay some of the contractor costs. This is sort of an owner-builder scenario. Do you think banks will give us alot of issues trying to borrow 30% as an owner-builder, knowing a contractor will be doing about 60-70% of the work?
Banks make relatively few construction loans and even fewer to owner builders. The main reason is that banks are risk-averse and they view owner-builders as risky. How do they know you have the skills needed to get the job done correctly, and on time and on budget.
In your favor, you already own the land and are only borrowing about 30% of construction costs, so you have a very low loan-to-value ratio. With such a high equity stake in the project, you have a strong motivation to get the work done and not fall behind on payments.
Assuming that you the builder have chosen is acceptable to the bank and that you meet the bank’s basic loan criteria for income and credit rating, and that you can convince the bank that you have the necessary skills to complete the project, you should be able to find a cooperative lender. To prove your skills to the bank, a portfolio of past projects you have completed, detailed building plans and specs, and a detailed cost estimate of the work that you will be doing will help you make a strong case to the bank that you have the knowhow to get the job done.
Your first step is to identify local and regional banks that make construction loans. If you already have a relationship with a local bank, that’s usually the best place to start. Schedule meetings with a few loan officers to describe your plans and ask what your options are. If you don’t have luck, consider meeting with an independent mortgage broker specializing in construction loans. They often have access to a wider variety of loans and lending institutions. Best of luck!
Financing Options for Large Renovation
I just purchased a home for $500k with 20% down (House appraised at $530k) and now want to do about $150k to $200k worth of work. Are construction loans an option for me or do I have save up the full amount?
There are a number of ways to finance remodeling projects. All loans assume that you meet the bank’s lending standards for debt-to-income ratio and credit score. Banks will look at your total income and total amount of debt. At some point, you are tapped out and banks will not lend you additional money. For second mortgages, you will also need to have sufficient equity in your home. Typical loan limits are for 80% of the home’s value minus what you owe on the property.
The two main approaches for financing a large remodel are trading in your current mortgage for a larger mortgage or taking out a second mortgage. Both types of loans have tax-deductible interest, with certain limitations.
The first option is sometimes called a renovation loan. This is a new mortgage that would cover up to 80% or more of the value of the remodeled home. You will have to pay closing costs all over again and may end up with a higher interest rates in the current market where rates are rising.
The second option is to keep your current mortgage and take out a second mortgage. This is usually in the form of a home-equity loan or home-equity line of credit (HELOC). The main difference is that a home-equity loan is for a lump sum at a fixed rate, while a HELOC is more like a high-limit credit card with a variable rate. You only pay interest on the balance as you draw funds. Some HELOCs waive all closing costs making them cost-effective for short-term financing.
Home-equity loans could provide some of the money you need, but you don’t have enough equity to fund this large a project. You may need to piece together the funds from different sources.
Other ways to raise cash include borrowing from your own 401K, or getting a personal loan from a bank. In general, you will get better terms with a secured loan, where you put up collateral such as a stock portfolio vs. an unsecured personal loan or line of credit. How much debt you want to take on is, of course, a personal decision.
It’s true that mortgage rates are still at historic lows, which won’t last forever, but I still believe cash is king. If you are able to save most or all of the amount and pay in cash, that might be your best option.
When Do I Start Paying Interest on Construction Loan?
My cost to build is $450,000 and my appraisal came in at $350,000. I put $100,000 in cash to close the loan. When I start taking draws, does the bank exhaust the $100,000 before I have to start paying interest on the draws from the loan of $350,000? Or do I start making interest payments after I take the first draw?
In general, the bank holds your down payment and uses it to fund the first draws paid to the contractor. So you should not start paying interest until you have exhausted your down payment and start drawing on the bank’s funds. The loan acts like a line of credit, so you will only pay interest on the amount disbursed. Your interest charges will go up as your loan balance increases, just like a credit card with a very high limit.
Most construction-only loans (where you already own the land) are interest-only. In addition, many include an “interest reserve” that pays for the interest during the course of the construction. This can help with cash flow, but increases the overall size of the loan.
Each bank has it’s own policies for construction loans, so it’s always a good idea to check with your loan officer about details of your loan.
Best of luck with your new home!
Michael J says
How Long to Get Construction Loan Approval?
Thanks for the info. At what point does the “closing” occur for both one-time and two-time closing construction loans? How long does it take to get approved?
A one-time loan (or the first part of a two-time loan) can close as soon as the bank has checked your credit, confirmed your income and assets, and completed the underwriting process. That includes appraising the new home, approving the contractor, and sometimes getting lien releases from subs. Because of the added steps compared to a conventional mortgage, the process usually takes longer, but the timing will vary depending on the bank and your individual circumstances.
When shopping around, ask the loan officer how long the approval process will take and also ask whether you can get “pre-qualified.” This is usually a quick and usually free process with a day or two turnaround, but is based only on preliminary information and is not a commitment.
“Pre-qualified” is not the same thing as “pre-approved”, but the two are often confused. To get approved (or “pre-approved) for a loan typically takes at least few weeks once the bank has all the information it needs from you. You will also need to pay an application fee.
Pre-approval requires a full review of your finances, but stops short of appraising a specific property or project. It is not a full guarantee that the final loan will be approved, but the closest you can get ahead of time. As long as you haven’t lost your job and the house appraisal is adequate, the loan should go through. It is a good idea to get pre-approval before you purchase land with the intent to build.
A two-time-closing loan has a second closing when the home is completed, you have been issued a Certificate of Occupancy, and the contractor is fully paid. You will need to pay additional closing costs, but may get a better rate than a one-time close loan. Also, on some loans you are free to shop around for a better deal on the mortgage.
Paula J Runner says
Hard to Get Construction Loan With Large Lot
What are the best types of lending institutions to contact for a loan to build a new house on 20 acres of land? We are finding it difficult due to the acreage. Any suggestions?
In my experience, locally owned banks, community banks, and credit unions are your best bet for construction loans. Lenders want familiarity with the local market and contractor. Also, these loans are typically held and serviced by the local bank and not sold on the secondary market. If you have an existing relationship with a local bank, that’s the best place to start.
If you cannot find a willing lender, you can try an independent mortgage broker, who has access to a wider variety of lenders and loan types, although you may end up paying higher rates and fees. Look for a mortgage broker that specializes in construction loans.
As you have discovered, many banks are leery about construction loans on large, rural building lots. Some specifically exclude lots over 10 acres. They see these loans as more risky since land prices are more volatile than house prices, making large lots more difficult to appraise. They view the land more as agricultural land than a building lot, and the land value may be too high relative to the house for their standard formulas. Banks are, by nature, very conservative and large rural lots may fall outside their comfort zone and lending policies.
If you have significant equity in your current home, you might want to look at a second mortgage or home equity line-of-credit (HELOC) as a way of funding construction of your new home. Some lenders are more flexible than others, so you may need to widen your search. Best of luck!
Construction Loans for Modulars
Are construction loans good when purchasing land and putting modular homes on property. Or is there another way to go?
Construction loans for modular are typically one-time-close construction loans, also called “construction-to-permanent” loans. One-time-close loans are favored because of the shorter construction schedule for a modular. On this type of loan, you will pay interest only while the home is under construction and switch to a conventional mortgage when the home is complete.
It’s best to start early to get pre-qualified, then get quotes from at least three banks and credit unions for rates and closing costs. If you already have a banking relationship with a local bank, that’s usually the best place to start. Local banks and credit unions are often the best places to look for construction loans.
The loan can cover both the land and home, but you may have to make a large down payment (10% to 20%) if you do not already own the land. An FHA loan would be your best bet if you cannot afford that type of down payment.
If the modular dealer is also the GC, the modular company may finance the project, especially if they own the land. In that case, you are buying a completed home using a conventional mortgage. This is the same a buying a home from a developer.
Best of luck with your new home! Meeting with a few loan officers is a good place to start.
Need Contractor for Construction Loan?
Do you have to have a contractor to get a construction loan?
In general, you can get preapproved for a construction loan up to a certain limit before you find a contractor, but the loan will not actually be issued until the “builder’s package” is completed and approved. This will include the plans, budget, and builder’s resume and financial data.
The bank will do its own appraisal, based on the plans, to make sure the completed project will be valued high enough to meet the loan-to-value ratio – or you will need to put additional cash into the project.
Also the bank must have confidence that the contractor can get the project completed on time and on budget. In most cases, any competent builder with similar projects under his belt, and who is not in financial trouble, will be approved. The builder, construction plans, and budget form the story behind loan, which is why these are sometimes called “story loans”.
Best of luck with your building project
Typical Closing Costs on Construction Loan?
Hello, I have recently approached a bank for construction loan. They have a 1% origination fee, which the bank would waive if I were to keep the mortgage loan with them. Is this typical practice among lenders? Next, the bank would also charge me about $2500 towards title company charges, escrow, appraisals, underwriting etc. Again, is this cost typical with a construction loan. Appreciate your advise.
Total closing costs, including the “origination fee” on a construction loan generally range from 2% to 3% of the loan amount. Closing costs tend to be higher on construction loans than traditional mortgages because they are short-term loans and banks do not resell them – so they make most of their money on fees. Also, these loans involve more work by the bank in terms of appraisals and inspections, and are considered more risky.
The origination fee is a negotiating point and is generally lower for bank customers and people with better credit scores. Fees of .5% to 1% are common. Some banks will negotiate on the fee or waive it, but you really need to look at the total cost of the loan. If one bank changes less on closing costs, but a slightly higher interest rate, you may end up spending the same amount on the loan.
If you are committing to a mortgage loan with this bank, it sounds like you might be one-time-close loan, in which the construction loan converts to a traditional mortgage when the home is complete. These have pros and cons – the main benefits are greater convenience, lower total closing costs, and less upfront risk for the borrower. You don’t need to apply for a second loan.
The biggest con is that you cannot shop around for a mortgage loan and may end up with a higher rate. On the other hand, if you believe that interest rates will be rising in the months ahead, locking in a permanent loan rate now could be a good thing.
It’s always good to shop around, and it never hurts to negotiate. If another bank offers a better deal, you may be able to negotiate a better deal with the first bank. Staring with the bank where you do most of your personal or business banking is always a good place to begin your search.
Best of luck with your new home!
Borrowing to Remodel Before Selling
What would be the best type of construction loan for an owner looking to upgrade and sell? My parents (both 65) have considerable debt. They have a line of credit and a second mortgage (about $130k together) on the house and about $30k in personal debt totaling in about $160k total debt. Selling the house and moving would be a good option to help themselves. But they live in a small ranch house in north NJ that needs repairs/upgrades. The good thing is, they live in a nice area and with updates the house should be worth up to $300k, maybe more. Is there a way for them to get a construction loan for the purposes of selling immediately after and getting the best value possible for their home? Your help is appreciated. Thank you
I don’t work in finance, so can’t say anything definitive. However, it doesn’t sound promising for your parents to get a construction loan, which is essentially a line of credit like your parents already have.
Whether they can get a loan, for how much, and at what interest rate depends on three factors: their credit rating, value of their home (or other assets used as collateral), and their debt-to-income ratio. With their current level of debt, I’m not sure how much more a bank will be willing to lend even if they have a good credit score and adequate collateral. They may be tapped out based on their income.
To get money for remodeling, people often use a home equity loan (or home equity line of credit) or second mortgage, or sometimes refinance (cash-out refinance) if the home has appreciated a lot and current interest rates are favorable. A loan officer can help you figure out which is the most cost-effective for your situation.
Since they already have a line of credit, the simplest approach might be to ask the bank to increase the limit on the line of credit. This would have minimal closing costs if they qualify and the bank is willing to work with them.
You might also look at an FHA 203(k) loan, which is a mortgage loan designed for renovation projects that takes into account the higher value of the improved property as collateral.
In most cases, it’s best to start with your local bank, who often offer the best deals to existing customers and may be willing to get a little creative. Sit down with a loan officer and ask what the options are. If that doesn’t work out, check out credit unions and private mortgage companies, which may offer more options for marginal borrowers, but at higher rates and higher closing costs. So-called B and C loans may be available, but at a higher cost.
Other options to consider: Co-signing a loan or using a larger remodeling contractor that offers their own financing.
Leslie A. says
Out-Of-State Construction Loans
I currently live in Nevada and own land in North Caroline where I plan to build a home. Can I get my construction loan in Nevada (or anywhere else for that matter) or do I need to get it in the region of my build site?
Thanks so much for this comprehensive article!
You can get the loan from any willing to lend you the money, but most banks are reluctant to make construction loans for out-of-state projects. Construction loans are considered risky to a bank so they want to be familiar with the contractor you will be hiring and the local real estate market.
If you have a good relationship with a local bank where you live, sit down with a loan officer there and tell him or her what you are planning. They can tell you quickly whether a loan from them is a possibility and offer suggestions for applying for a loan out of state.
An independent mortgage broker who specializes in construction loans could also be a good resource.
Amy M says
Low Appraisal on Construction Loan
We are just about to begin the application process through a local credit union. We will use a contractor when we build. Our loan officer suggested the contractor’s fee may not be included in the appraisal at completion and therefore would need to come out of pocket because there would be a shortage in the value.
Is this common? Can you further explain this situation? Thanks!
Not sure if you are applying for a one-time-close or two-time-close construction loan. With either type of loan, however, there is a chance that the completed house will appraise for less than the construction costs plus the cost of the land. Banks these days are very conservative with construction loans. They do not want to lend more than they can easily recover by selling the house in the event of a foreclosure when the house is completed.
So a low appraisal is in the bank’s self-interest. It forces the owner to put more cash into the project and reduces the risk to the bank.
In any case, appraisals on construction loans are difficult as they are based on a set of plans rather than a real house. Sometimes the low appraisal is due, in part, to an inexperienced appraiser or one who is not familiar with the area. Some banks use appraisers selected at random through a service rather than someone they know and trust.
It helps if you are using a contractor that the bank works with regularly. In some cases, the contractor can recommend a bank that will provide a more generous appraisal. In any case, the appraisal process is part art, part science, and you can get very different numbers from two appraisers.
On the other hand, you should not ignore an appraisal that is far less than the cost of the project. This may be a signal that you are paying too much for the house and it is not a good investment. The risk is that you will be “underwater” as soon as the house is completed. If you are unable to get permanent financing and are forced to sell, or need to sell within the next few years, you may walk away with a substantial loss.
I’m not sure about the relevance of the “contractor’s fee,” which is usually built into the cost of construction on a fixed bid. Is this a line item in his bid? Are you considering a cost-plus contract – not a good idea on a new home. In any case, the bank is more interested in the value of home when completed than the cost of construction. Perhaps the loan officer is trying to tell you that you are paying too much for the new home and that the contractor’s fee is excessive.
Get clarification from your loan officer before proceeding. If necessary, consider working with a different bank. Best of luck with your new home!
Mike B says
Second Appraisal on Two-Time Loan?
I am in the process of securing my construction 2-step loan. The $500,000 appraisal includes the land. I own the land, with no mortgage (value 35k).The bank has offered a $400,000 construction loan.
So, if I build the home for $450,000. Would I just need $50,000 in cash, plus closing costs.
Then for permanent financing: Is another appraisal performed? Will the loan be for $450,000?
I will need cash for closing costs, and no other cash contributions, correct?
A construction loan is essentially a line of credit for 6 -12 months, like a big credit card with a very high limit. Since you own the land, that will be considered part of your down payment – typically 20 to 25% of the appraised value of the completed house.
If you exceed the approved loan limit, you will need to contribute cash, as you suggest. You will also need cash for closing costs, which tend to be high on construction loans, often 3% or more of the principal. Also, if your loan has an “interest reserve” that allows you to avoid interest payments during the term of the loan, some of the $400,000 loan will be used to pay interest rather than construction costs.
The lender should provide you with a Loan Estimate (formerly called a Good Faith Estimate) that details all of the loan costs. If anything is unclear, sit down with your loan officer and get answers to all your questions. That’s part of what they get paid for.
You will need another appraisal, and need to qualify again, for permanent financing. The is a completely new traditional mortgage loan which you can get from your current lender or from any other willing lender. The maximum size of the mortgage will depend on your down payment (including the land value), appraised value, your debt-to-income ratio, and credit score as with any other mortgage. If the new home, with land, is appraised at $500,000, it is likely you can likely borrow $450,000 if you qualify for a loan of this size. Your current lender should be able to provide additional details on their lending policies.
Best of luck with your new home!
Pros and Cons of Construction Loans
We bought some land and want to build our home on it soon and have two ways we can go about doing this. We can go with a custom builder we like but would need to get a construction loan and, when the home is complete, a VA loan. Or we can go with a reputable realtor/home builder and get a VA loan after the home is completed (no construction loan). If we go with getting a construction loan would we have to pay out interest money each time a draw is made and how much would that be on a $180,000 home. The realtor/builder’s homes are about $15,000 to 20,000 more but wouldn’t include the construction loan. What would you recommend? Thank you!!
As with much in life, there are pros and cons to each approach.
A two-time-close construction loan, like you are describing, is like a line of credit with a balloon payment at the end. The full cost of the loan is any closing costs, including “points”, plus the interest payments. Closing costs tend to be high on a construction loan because of the greater risk to the lender and added work of servicing the loan (qualifying the builder and plans, inspecting construction for progress payments, etc.). However, interest payments are only on the amount released, so they start very low and grow over time. The faster the house is built, the less you pay. Also, some banks allow you to delay all payments until the end of the loan, but that raises your loan amount since you are borrowing more to cover the interest payments.
For example, on a $180,000 loan you are likely to pay a minimum of 3% in closing costs ($5,400) plus interest on the funds disbursed, starting low and increasing. On a $180,000 loan at 4% interest over 6 months, your interest payment would be around $4,000, the exact amount depending on how fast the money is released. Rounding up, your total loan costs may be around $10,000.
On most types of loans, lenders are required to provide a “Loan Estimate” (former called a “Good Faith Estimate”) showing the actual costs of the loan once you have applied. You should also ask for an estimate before applying, which the bank should provide although not a legal requirement.
Your risks with this approach are the that the house will take longer to complete or cost significantly more than the estimate, always a risk with custom homes. Read more on Cost Overruns.
If you buy through the builder/realtor, you should know ahead of time the exact price of the home – once you have made all your selections of finish materials, appliances, etc. You are paying a premium for greater certainty, but the peace of mind may be worth the difference. And some of the savings from the custom approach may vanish as the final bills come in. Construction projects almost always cost more than the original estimate – it’s the nature of the beast.
In comparing the two homes, make sure you are making an apples-to-apples comparison. For example, what is included in each project: all permits and fees, appliances, landscaping, utility hookups, etc. The builder’s home price may or may not include all these items. The complete house package may include most of these things, but may still omit some big cost items to make the price attractive. Impact fees and fees to the town or to utility companies for utility hook-ups may be excluded.
Look over the list of Site Development Costs. Don’t be afraid to go over the list with each party. Ask what costs you should anticipate on top of the contract price or house price before you move into the house. Ideally, these costs are shown as “exclusions” in the bid, but often are not. An honest contractor or developer should be upfront about these costs when asked. Read about Budgeting for Site Development.
Also, compare the specifications for the two houses. Do they have the same quality siding, flooring, roofing, windows, doors, etc.? It takes a little legwork to do this, but otherwise you may be comparing apples to oranges making it hard to make a realistic cost comparison.
With either option, make sure you are working with a reliable and trustworthy builder – that’s the best guarantee of a successful project and a satisfied customer. Best of luck with your new home!
THANK YOU so much for the information!! I really appreciate you and you have helped me better understand things!!
Karen White says
Credit Card Debt and Construction Loans
We have applied for a construction loan on land that we own. We are being told by the bank that it’s not our debt ratio that’s a problem but the high balance on one of our credit cards. How can that be a reason to turn us down?
In general banks are skittish about construction loans, which are more risky than traditional mortgages. In addition to the usual risks, there are risks that the house will not be completed on time and on budget, as well as risks that it will be worth less than the cost of construction when it finished. Also, if the homeowner defaults for any reason, the bank is left with a partially built house.
For these reasons, banks have more stringent lending guidelines on construction loans and typically require higher credit scores, lower debt-to-income ratio, and higher down payments. In addition they must approve the builder, the building plans, and appraised value of house when completed.
If you are a borderline borrower under their guidelines, they might still approve if you have strong “compensating factors” such as a larger down payment (over 20%), very high credit score (over 740), or extra cash in the bank.
Carrying a high unpaid balance on a credit card does two things: raises you debt-to-income ratio and lowers your credit score. Since the bank told you that the ratio is OK, maybe it is the credit score that is hurting you.
I would first ask for clarification on why your loan was rejected, which the bank is required to provide if requested within 60 days under the Equal Credit Opportunity Act (ECOA). Also ask what steps you might take to improve your chances of getting a loan — such a lowering the credit card balance to an acceptable level. If you were denied the loan due to your credit score, the bank is required to tell you your numerical score and the name and contact information for the credit agency they used. Ask how to get a free copy of the credit report, which you are legally entitled to.
If you feel that the credit report has inaccurate information, not an uncommon occurrence, than you should contact the credit agency to dispute the misinformation. If you have trouble getting your credit score or the credit agency will not fix the inaccurate information, contact the Consumer Finance Protection Bureau (CFPB), a federal agency that supports borrowers.
Also contact the CFPB if you feel you have been discriminated against due to race, gender, marital status, or age. Lending discrimination is illegal under the Equal Credit Opportunity Act (ECOA), which is enforced by the FTC.
One option might be a secured construction loan. If you own other property, you may be able to use it as collateral for your construction loan. Collateralized loans reduce the bank’s risk a great deal, making them more likely to open their purse to you. Also, if you already own the property, that can be used to lower your loan-to-value ratio, which is the same as raising your down payment.
Finally, shop around. Different banks have different policies and practices around construction loans. If you already have a long-standing relationship with a bank, it’s always best to start there. Best of luck in securing a loan and getting your project underway!
Does VA Provide Construction Loans?
I am a disabled Veteran, would I be able to use my VA loan as a construction loan?
It is possible to obtain a VA construction loan, but not easy. You have to find a bank willing to go along with your plan and most do not like to provide no-downpayment construction loans, even if they are guaranteed by the VA.
Banks consider construction loans more risky than mortgages, as they are loaning money on the promise that you and your contractor are going to follow through and get the home built on time and on budget – not always the case.
You can use your VA loan for permanent mortgage financing, which pays off the bank that issued the construction loan. The tricky part is finding a bank (or builder) to finance the construction phase. If you have a bank where you or your family regularly does business, I would start there.
You might also consider buying a new home from a developer using the VA loan. Larger developers have the financial strength to build homes “on spec” where they finance the construction rather than the buyer.
Best of luck in getting the financing you need. You can read more at these links: VeteransUnited.com Military.com
trish miller says
Where to Look for Construction Loans
I am looking for a new construction loan to buy land and build a small home and business. I live in West Virginia and am not sure where to seek for this loan: local bank or out-of-state, or whether to use an internet search to get the best offers and/or interest rates. Any thoughts or ideas?
With any type of loan, I always start with a local bank where I have an existing relationship. Many banks do not provide construction loans at all — especially out of state. Your best bet is to approach banks with ties to the local community: community banks, credit unions, and cooperative banks.
A construction loan is sometimes called a “story” loan because the bank needs to trust in your story that you can complete the land purchase, construction, and – in your case – build a business, so it ends up with something of value as collateral. If you already own the land, then that is part of the collateral and can help with this type of loan.
Schedule a meeting with the loan officer at your bank, explain to him/her what you are trying to achieve and find your options are. If you own other property, you can sometimes leverage that for bridge financing in the form of a home-equity loan.
If you are also trying to borrow money to start a business, I’m not sure if you can fold that into the mix. That would take a little creative financing, something that a local bank is much more likely to consider.
You’ll need to consider whether to look for a one-time-close (construction-to-permanent) or two-time close loan. There are pros and cons to each, but one-time-close loans are not available in all markets
Diane Nolte says
Can I Borrow Down Payment?
Is there any way we can borrow down-payment money and roll it into the mortgage after the project is done. We have put a small down payment on a house to be moved (not a mobile home) and need a construction loan. We do not have near enough to put 25% down and want to roll the construction loan over to a USDA guaranteed loan. At that time, we would pay off the friend who loaned us the money for the down payment.
In general, banks will not allow you to borrow down-payment money. One exception is FHA loans, which may allow you to borrow down-payment funds from specific approved lenders, but these do not include family, friends, or other interested parties.
All banks, however, will allow friends or relatives to gift you money to use as a down payment. In general, they will want signed documentation by the gift giver certifying that the money is a gift, not a loan.
While USDA-guaranteed loans are not available for construction loans, FHA does provide 0-downpayment mortgages to qualified borrowers, which could help you out. Another option to consider is an FHA loan. FHA does provide construction-to-permanent loans with lower down payments than required by traditional lenders, so this might work for you if you qualify. Read more on FHA loans.
Walk Away from Construction Loan?
We took a construction to perm loan and started building .. but unfortunately we did not get the schools we hoped for our special needs kids. Can we walk away now without incurring any loss ?
Assuming that you have taken out the loan from a bank or mortgage company, you are responsible for the loan. If you default on the loan, you will lose your earnest money and any payments you have made, and your credit rating will take a big hit.
You can try to sell the house to a third party who is willing to purchase a partially built home. In some cases, you can negotiate with the bank to accept the deed to the house without going through foreclosure. That would spare you future credit problems.
At this point, you should meet with your loan officer, explain your situation, and see if they are willing to work with you on a solution other than foreclosure.
You can find a good discussion of these issues at this link.
Miriam Sawtschenko says
Co-Signers on Construction Loan
My in-laws are going to build a home on land that my husband and I own. They will be selling their present home, which is fully paid for, in time to repay their construction loan in full upon completion of the new house. We are gifting them the land, and will be on the deed as co-owners. Can the construction loan be in both names, and will lenders allow us to pay it back 100% ? The new house will be much smaller than the old one, so equity is not an issue.
While mortgages of this type are common – for example, when a parent “co-signs” a loan — whether you can get a construction loan this way is less clear and will depend on the policies of the individual bank. Construction loan policies vary a lot from bank to bank, so your best bet is to sit down with a loan officer at a couple of banks that you already have a relationship with. Explain what you are trying to achieve and what the options are.
If I understand you correctly, you will jointly hold the land deed, but it’s not clear whether you will also be co-owners of the house. Regardless, it is possible for more than two people (related or unrelated) to apply for a mortgage or construction loan.
In fact, three or four people can sign a joint mortgage loan that only one or two of the people will own – or all four may own the property as joint tenants. Everyone who signs the loan will be equally responsible to pay it back, while the owners of the home and the land would be the ones at risk for losing the property to foreclosure.
The advantage to the weaker borrowers is that they can benefit from the higher income and higher credit scores of the stronger borrows and can usually borrow more money on better terms. However, the people with stronger credit ratings risk seeing their ratings deteriorate if there is trouble repaying the loan. Another potential disadvantage is that all parties to the mortgage are “equally and severably liable” for the full mortgage amount. The bank will go after whoever has the money regardless of who lives in the home.
There are further complications if there is a divorce of other disagreement and one or more parties want out before the loan is paid off. This is not easy to achieve without refinancing. Also there are two main types of joint ownership to consider: Joint Tenancy and Tenancy in Common. If you are considering borrowing and possible owning property jointly, you’d be wise to discuss your options and your legal responsibilities and risks with a real estate lawyer.
Read more on Joint Mortgages.
Builder Bankrupt After First Draw
A few years back I got into a construction loan agreement with Chase. Only the first draw of $50K was made to pay the builder to purchase the land and begin work before he disappeared and filed for bankruptcy. Can I sell the land or is it considered collateral to the loan and therefore linked to it? I have the land title and I am paying regular taxes on it.
It sounds like the land title passed to you at some point based on the terms of the loan. On some loans, title passes to the owner after a certain percentage of the loan is repaid.
However, if you are still paying off the loan, then the bank holds the first lien on the land (or the title) and will require repayment in full when you sell the land. If the loan has been paid in full and discharged, then the bank should be out of the picture.
Before proceeding, I would take a close look at the loan documents and title and speak with bank’s loan officer – assuming you are still paying the loan. They will want to make sure there are no liens against the property related to the bankruptcy. For example, was any preliminary work done on the project that the builder never paid for?
Regardless, I don’t see why you can’t sell the land and pay off the loan. But first check with the bank and it wouldn’t hurt to run it by a real-estate lawyer. There’s lots of fine print in any bank loan for dealing with these types of situations where things don’t go as planned.
Best of luck – hopefully the land is worth more now than when you bought it!
How To Manage Progress Payments
I am the homeowner and I have hired a GC. We are about to close a construction loan and begin the draw process. Should I open a bank account just for this project and give my GC access to the funds?
Should I just give my GC money as he presents itemized need?
Generally, the bank makes the progress payments directly to the contractor after inspecting the job for completion of each phase of work. The final payment is usually endorsed jointly by you and the bank — a good idea so make sure this is your bank’s policy. This gives you some leverage to make sure the quality of the work is acceptable and that all punch list items are completed before releasing the final check.
ron tangen says
I think it is a bunch of bull when you are almost complete with a home that will be in the 300k + range and you are 90% complete and cant get a loan to finish because you paid cash for everything to get to that 90% complete. You would think that that would be an asset to the bank !!!
Cathy cox says
We are building a new home that unfortunately went into receivership,we contacted our lender who advised us to let them know before the interest only on our loan came to an end,we did this 6 weeks before that date and we were advised by the bank that we were given another 2 months on intrest only,but now they have taken full payments for interest and principle and said we have to apply for funds to finish our home which has now been taken over by another builder,is there anyway we can reverse this? As for 1 we had contacted them and seconds we are paying rent on top of this mortgage,all due to no fault of ours!! Cath cox