Understanding Construction Loans

How do Construction Loans Work?

Once you’ve made the decision to build a custom home, you will probably need to apply for a construction loan. Obtaining a construction loan is an unknown – and often confusing – process for many people, which is why we decided to ask our friends at First National Bank to write a guest blog on the topic.

What is a Construction Loan?

A consumer construction loan is a loan designed specifically to build a house with the homeowner (rather than the builder) carrying the financing. It differs from the traditional mortgage loan in that the term is usually only for twelve months and works more like a line of credit than a loan.

How it Works

After application, you will be approved for a maximum amount which you will later borrow from as you need money to pay your contractor for work performed. As the builder progresses in the construction of your home, he or she will need to pay for the work that’s been done (either by your builder or subcontractors). Each month your builder will provide you with invoices to submit to the bank. This is called “a draw request”. When you submit the draw, the bank will review the invoices and then fund the amount needed to pay the invoices.

As you draw against the line, you will pay interest on the amount you have borrowed. Each month, as the project progresses, your payment will increase until the home is complete. At that time, the bank will refinance your construction loan into a traditional mortgage.

Qualifying

The bank will qualify you for a traditional mortgage and construction loan at the same time. In addition to the same types of documents that you would normally need when applying for a mortgage, you will also need to provide plans, budget and specs for the project. The plans, budget and specs will be used to obtain an appraisal so the bank can know what the value of your home should be when it is completed.

Do I Have to Sell My Current House?

This depends. Your lender will need to determine if you can make the payments on all of the debt/loans that you have whether or not you choose to sell. Keep in mind, if you need to bring any out-of-pocket cash to the deal, you may want to use the equity in your current home to take care of that. There are other options available to access this cash if you’d prefer not to sell. Each loan is different, so you will need to discuss these options with your construction lender.

What is Your ‘Cost’?

The cost is the amount that you paid (or will pay) for the land, plus the amount of your construction budget. For example, if you purchased your lot for $100,000 and your budget for construction is $400,000, your total ‘cost’ is $500,000.

What is Your ‘Value’?

The value of your project will be the amount that the appraiser deems the project to be worth when compared with similar homes in the area. They will determine this by using your plans, specs and budget to project what your home will look like when completed.

What is Your ‘Equity’?

Equity is the amount of money, or value, that you have in the project. If you purchased the $100,000 lot with cash, then you have $100,000 worth of equity. If the lot cost $100,000 but you paid $80,000 in cash and borrowed the remaining $20,000, then you would have $80,000 in equity.

What is a ‘Contingency’?

A contingency is essentially an ‘emergency fund’ in case of cost overruns or change orders that may occur during the course of construction. This amount is generally 10% of the budget, but can be waived if the borrower meets certain criteria.

How Much Can You Borrow?

First National Bank is able to loan up to 80% of the Loan-to-Value, or 80% of the Loan-to-Cost, whichever is less (80% is standard for most banks, although some are limited to 70%). Using the project scenario where the cost is $500,000, your bank could loan you 80% of that amount, which is $400,000. This means that you would need to have $100,000 in equity to bring to the table.

If you had purchased your lot for $100,000 and paid cash, your equity requirement would be covered. If you had purchased your lot for $100,000 and only paid $80,000 of the purchase in cash, you would need to have an additional $20,000 to cover the equity requirement.

Also, it is important to remember that if the appraisal comes in with a value of less than $500,000, the bank can only loan you 80% of that value (80% of Loan-to-Value or 80% of Loan-to-Cost…whichever is less).

Obtaining Plans, Specs and Budget

You can get these from your builder and architect before or after you apply for your loan. Just keep in mind that the appraisal cannot be ordered until your lender has these in hand.

Know Your Builder

Who are you working with? Is it someone reputable? It is always a good idea to check references, talk with industry professionals (i.e., realtors, lenders, architects, etc.) to see if they’ve worked with your builder before. Ask for addresses of projects they’ve built in the past so that you can determine the quality of the build. Your builder will generally need to be deemed an ‘approved’ builder through your lending institution. Contact your construction lender for details on this process.

 

Jen AmmermanAbout the Author: Jen Ammerman has worked for First National Bank since 2004 and is currently the Consumer Construction/Mortgage Lender. She is heavily involved with the Northern Colorado Home Builder’s Association and currently serves as the Membership Committee Chair for that organization.