NEW CONSTRUCTION LOAN BASICS
A construction loan is different from your regular mortgage loan. With a construction loan, you’re esentially given a line of credit up to a specified amount. You request money from your lender and pay interest as you go.
Think about your construction loan as a credit card that will only work as long as the home is under construction. After construction ends, you will then get a mortgage on the home which will pay for the balance of your construction loan.
TYPES OF LOANS
ONE STEP LOANS
With this loan type, you use only one lender for both your construction and mortgage loans. When you close, you close on both at the same time.
This type of loan is a great option if you know exactly what your home will cost when it is complete. Any additions like a larger bathroom, will have to be paid in cash because this loan has no room to move around.
TWO STEP LOANS
In this type of loan, the construction loan and mortage are separate from each other and you close on your mortgage upon completion of the home. This loan give those building more customized homes more flexibility to add any changes (within reason) to the home if needed.
DO I NEED TO SELL MY CURRENT HOME BEFORE I GET A CONSTRUCTION LOAN?
If you currently live in a home that is paid off, the answer will most likely be no. But for example, if you have $300,000 left to pay on your current mortgage and you’re requesting a new construction loan for $700,000, it will be a matter of if you’ll be able to get approved for a debt of $1,000,000.
The lender basically will want to know if you can make payments on all of your loans you’ll be taking out. One option would be to sell your current home and rent during this process to eliminate the extra headache.
USE A PROFESSIONAL LENDER
Once you are ready to start the new construction loan process, meet with a professional lender to help you answer your questions. HBASE has a number of members that are able to help you through the process.
GET HOMEOWNERS INSURANCE
Before you are even able to use money from your construction loan on the home, you are required to obtain a homeowners insurance policy that needs to include ‘Builder’s risk coverage’. This type of coverage will shelter you from any financial responsibility if there is any theft, damage or liability as your home is being built.
STEPS TO FINANCING YOUR NEW CONSTRUCTION LOAN
STEP #1: APPLICATION FOR FINANCING
To begin the process for construction financing, it is important to start with the end financing in mind. You will need to apply with a lender who provides the permanent financing. They will typically require the following documents:
- Copies of your most current pay stubs covering a 30 day period
- Copies of your complete Federal tax returns with all schedules for the two most current years
- Two years of W-2’s, 1099’s, K-1’s from all sources
- Two most recent monthly (or most recent quarterly) bank statements and investment accounts
- Divorce Decree(s) (if applicable)
- Bankruptcy Documents (if applicable)
- HUD-1 from sale of previous residence
- If veteran, copies of your DD214 or discharge papers and Certificate of Eligibility
- Driver’s license
Upon review of your application and documents the lender will issue you a prequalification letter and discuss the permanent financing options. Most lenders who provide the permanent financing have connections will construction lenders or have access to the construction loan. It is important to get completely approved so that you can successfully complete the financing once the construction of your new home is completed. That is why it is so important to begin with the end in mind.
It is important to note that some builders provide financing for the construction of your new home and with the mortgage lender’s approval letter, the builder will provide the construction loan covering all costs of the project. If that is the case, the lender and builder will work closely together. Typically, the builder will purchase the lot and be on title for the project. This means that your transaction will be considered a purchase loan. You will put together a contract with your builder and the appraisal and final loan to value will be based on the purchase price.
If you own the lot and the mortgage lender provides the construction loan as outlined below, your transaction will be structured as a refinance and you may be able to take advantage of equity gained during the building of your home and you may not need to come up with as much money for the down payment. It is important to review both options when you first meet with your mortgage lender to determine what is best for your situation.
One last thing to note regarding financing. Make sure that you find a lender who offers long-term locks. For new construction, you should have an option to lock up to 1 year. During an increasing rate environment it can be very frustrating to see your interest rate increase during the construction process. Protect yourself with a long-term lock!
STEP #2: INTERIM CONSTRUCTION LOAN SECURED
The interim or construction loan includes all costs associated with the building of your new home.
- Lot payoff
- Interim Costs (interest costs for construction loan)
- Costs to build including design
The lender will order an appraisal and submit your plans and specs to the appraiser to determine what the appraised value would be upon completion. The construction lender will review your supporting documents and close your loan. The construction loan is a line of credit. It works just like a credit card as you need money to pay down the construction costs, your loan balance will increase. This charge is called a draw. It is typical to have several draws during the process.
- A draw request is completed by you or your builder.The construction budget is typically used to detail how much and when the funds will need to be withdrawn
- The draw request should be signed by you and then forwarded to the construction lender
- The construction lender should send an inspector to the home to confirm the completion of your budgeted items
- The draw funds will become available to the builder
It is important to note that you do not pay interest on funds that are not yet drawn. The credit balance will increase as you take draws. As you take more draws, the amount of monthly interest that will be due to the construction lender will increase. To avoid unnecessary interest, you should only take draws on work that is completed to your satisfaction. The payment of construction loan interest is made monthly.
STEP #3: CONSTRUCTION COMMENCES
As mentioned in Step #2, during the construction process the only financing considerations you need to be concerned about are draws and interest rates if you have not locked in your permanent financing. If you decide to do any upgrades during the process, it is extremely important to involve your lender in those decisions and make sure that you have the funds necessary to make changes.
STEPS #4 & #5: CONSTRUCTION & PERMANENT LOAN COMPLETED
As your construction process draws to a close it is important to review all costs with your builder and your lender to make sure that there are not any last minute changes. Your permanent lender will require a Certificate of Occupancy issued by your local municipality. They will not be able to close your loan without this certificate. It is also very important that your builder and lender are aware of any items that will not be completed prior to the permanent loan closing such as exterior items like paint, landscaping, etc. If there are remaining items, it is possible to close the permanent financing as long as the builder is willing to put aside funds in an escrow account with the title company to cover those costs.
Beginning October of 2015, there are new rules that have been put in place by the Consumer Protection Finance Bureau (CFPB) that do not allow you to make any changes to your loan amount three days prior to the closing. Your builder and lender will need to work closely together to finalize all numbers at least a week prior to closing or there could be a chance that your closing is moved back. The CFPB does not allow for you to waive this three day waiting period so it is essential that you work with a reputable lender who will help you monitor the process to make sure you close on time.
The construction loan process is more complicated than a normal mortgage loan. It is very important to chose a lender with experience and who pays attention to the details. This will ensure that you will have a smooth closing process and be able to enjoy your new home without last minute issues.