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UNDERSTANDING A CONSTRUCTION LOAN
When you apply for a loan to build a home, the lender doesn’t have a complete home as collateral, so qualifying for a loan can be challenging. The lender will want details about the home’s size, the materials to be used and the contractors and subcontractors who will do the work. The general contractor can pull all this information together with their estimates. All contracts must be signed by borrower and contractor.
The bank will not only look at the information above to qualify you, but will also review your credit history and your debt-to-income ratio (this includes all your monthly debt payments plus your mortgage payment, estimated property taxes, Homeowners Insurance and any Association fees) to ensure affordability.
SELECTING THE RIGHT LOAN
Construction only loan
Borrow to pay for the construction
Only pay interest on outstanding loan balance during construction phase
Loan balance converts into a permanent mortgage upon completion of construction
Lock mortgage rate at beginning of construction
Typically a 20% down payment is required to begin construction (lower down payment options may be available)
May be able to use land value toward down payment
One set of closing costs and fees
Borrow to pay for construction, then get a mortgage to pay off construction debt
Can’t lock maximum mortgage rate at beginning of construction
May allow smaller down payment based on construction loan value
If your financial health changes during construction, may limit options and rates for mortgage
Two sets of closing costs and fees: one for construction loan, one for complete home mortgage
CHOOSING THE RIGHT BUILDER
Find a builder that has built the kind of house you want in terms of price, style and size. Look into the builder’s credentials with the local homebuilders association and ask for references from previous clients. Ask your builder for proof of insurance and check with the Better Business Bureau to see whether there are any complaints against the builder.
APPLYING FOR BUILDING PERMITS
It’s essential that you get the right building permission and the necessary permits required to build your various structures. By getting the right permits, you will avoid fines and work delays. If you proceed to build without the proper permits, you expose yourself to penalties, including having to take the structure down after you’ve built it. The right permits for construction projects will also ensure that safety standards are met. It’s important to adhere to building regulations because these codes are in place for a reason and public safety is one of them.
The method of applying for building and construction permits will vary depending on the state that you live in. You can get all the information necessary at your state government’s website. Leave ample time for the permit process, because it can take weeks or months for your permits to come through. Most lenders will require a copy of your building permits before the loan can close.
BUILDING PROGRESS INSPECTIONS
Lenders will conduct routine inspections as the home is built. During this period, the lender pays the builder in stages, called “draws,” and usually sends an appraiser or inspector to make sure that construction proceeds as planned. This process keeps the construction draw amount and completion percentage in line.
PLANNING FOR UNEXPECTED COSTS
Cost overruns can occur when borrowers change their minds during the construction process or if the price of materials increase. It is recommended to have a 10% overrun budget available.
How do I select what builder to use with so many to choose from?
When hiring a builder it is important to remember you are buying a service – not just a product. The quality of service the builder provides will determine the quality of the finished product and your satisfaction with it.
Here are some questions to consider when choosing a builder:
- Am I comfortable with them and do I feel they are a good fit?
- Are they quality oriented and do they offer a warranty?
- Are they a good listener and will they accept changes?
- Do they primarily build custom homes or “spec” homes?
- Can they supply me with multiple references from other people they have built for?
- How long have they been in business and can I see other homes they have built?
- What is their reputation in the building industry? Do they have subcontractors who would speak highly of them?
- Are they a member of the HBA (Home Builders Association) and do they abide by their standards?
- Have they built different home styles and have they ever managed a project like mine?
- Can they offer ideas and guidance throughout the entire building process?
- Can I review all of their contracts and required documentation in advance?
- Am I comfortable with the terms of the proposed project?
When do I have to make our down payment?
At the time the bank closes on your construction loan, you will have to furnish your down payment. The down payment is held by the bank and is used to fund your builder’s draws. Once they have exhausted your funds, the bank will begin to fund the builder’s draw requests from your construction loan. There is no interest paid on your down payment.
What if I want to make changes during the construction project?
Changes are never a problem and are a common occurrence with custom home construction. If your changes result in a decrease in square footage, change in the home type (two story to a ranch, etc.) or some type of change that results in the value of your new home decreasing, you will need to notify the bank immediately. These may affect your loan and changes like this should not be made prior to talking to the bank.
It is not uncommon for things to change during construction. Even though your builder may do a detailed review of your floor plan prior to starting construction, once they are in the field they may even suggest minor changes and modifications that will improve the functionality of your new home. They will encourage and welcome your feedback and thoughts as to things you may want to change while your home is being built. Changes can result in additional costs or a decrease in costs depending on what the change is. Unless you have allowed funds in your construction loan for cost overruns, be prepared to pay for these changes in cash at the time you request the change.
What happens if there are construction delays and construction is not complete when the loan comes due?
You typically have 9 months to 1 year to complete the construction. It will be important to keep in close contact with the bank on any delays, however the bank will typically be aware of delays through the inspection process. Your bank will work with you on these issues on a case-by-case basis.
When do loan payments start?
With a construction-to-permanant loan your interest only payments will typically begin 30 days after your loan closing and will be based on any drawn funds. You will pay interest only on the drawn balance during the construction phase and then your regular principle and interest payments will be begin during the next billing cycle for the permanent mortgage.
Get a head start on the construction loan process, with our Home Construction Guide. Download yours today!