Financing for Building a home
Though the current economic climate presents some challenges, the time to build is now. Many builders and sub-contractors are seeking construction work and are willing to negotiate on pricing and terms in order to win your job. Prices for construction materials can also be a bargain in comparison to the boom years. The current challenges in building a new home are the real estate market and construction financing.
It's not news that the banking industry, real estate market, and economy have taken a downward turn over the last three years. National construction lenders like IndyMac Bank, National City Bank, Chase, and others have taken huge losses on new home construction loans. Regional and local banks offering construction financing have also experienced financial losses. Many lenders have closed their construction lending operations completely, and those who are still lending have severely modified their qualification policies and procedures. With fewer lenders, fewer dollars available, and more stringent lending practices, securing financing for building a new home can be tough—but it's not impossible. We'll walk you through the basics to help you navigate the process.
Construction Loans vs. Home Loans
To understand how to qualify for a construction loan in today's market, you should understand that construction loans are very different from typical home loans. With a traditional home loan, you make a down payment, take possession of the home, and then make a payment to the lender each month. With a construction loan, you are asking the bank to estimate the value of something that does not yet exist—and then lend you money for it. A lot can happen during the typical 12-month construction process—from the expected construction delays and cost overruns to the unexpected—like a change in your employment situation or your builder going out of business. The risk to the bank is much greater, so it exercises greater caution in loan decisions.
A construction loan is really a reimbursement process. The bank does not advance construction funds; it will only pay for construction items that are complete. Each month you must submit a draw request along with supporting documentation to prove that building is progressing. The bank reviews the documentation, a third-party inspector visits the building site, and only then will the bank issue a reimbursement payment for the construction phases that are complete.
There are three major elements to qualify for a construction loan. Think of these three elements as the sides of a triangle. All three sides must connect for a construction loan approval. One side is the construction budget, including all the costs associated with building a new home. Side two is the appraisal value, or the estimated value of the new home when completed. The third side is the foundation of the triangle, representing the construction loan amount, including land equity and your down payment. Your personal financial qualifications determine this amount.
Cost to Complete
The Cost to Complete is your construction budget, and comprises the following elements:
- Land—If you are buying land or if you own a building lot you need to consider the purchase price or land payoff costs in your new construction budget. Understand that current values may be lower than in prior years and be conservative in your market valuation, as the bank will be conservative, too. Be aware that land improvements like water, sewer, grading, and utilities should be included in your construction budget. Land development costs can easily be overlooked and underestimated.
- Soft Costs—You will need home plans, site plans, permits, engineering, and other soft cost items. These expenses are often overlooked as part of the construction budget, as you will probably have to pay for them prior to closing on your construction loan. Construction lenders in today's market will want to verify that your house plans are complete and have been approved by your local building department.
- Hard Costs—These are the typical costs used in per square foot cost breakdowns, and they include site work, excavation, building materials, labor, and general contractor fees. Your contractor may give you a fixed price contract for these items. Homeowners and builders tend to focus only on these costs when they are developing their budgets, mistakenly overlooking the soft costs and land development expenses.
- Reserves—Most construction lending programs require you to have a reserve fund. Your contingency fund should be 5 to 10 percent of your total hard and soft costs. This amount should be added to your final construction budget, to be used for unplanned cost overruns. The contingency fund gives both you and the lender some security for unforeseen expenses. Many lenders also want an interest or cash reserve. The cash reserve can vary, but most programs will require you to have at least an additional six months of principle and interest payments in cash reserves.
- Loan Closing Costs—Every loan will have fees that will be charged to the borrower: appraisal fees, title fees, underwriting fees, origination fees (points), and construction loan administration fees, to name a few. The lender will produce a Good Faith Estimate (GFE) to disclose all the fees and costs to you. They can add up to as much as 4 percent of the loan amount.
The plans and specifications will need to be reviewed by an independent appraiser. They will calculate the value of your building lot and completed home and compare it to recently sold and comparable homes in the area. The construction lender must verify that the completed home value will conform to the local market. With an excess of homes for sale, foreclosures, and the general economy, home values have declined in recent years. Anticipating further declines in the market over the months it takes to build your home, your lender could hedge down the appraisal value.
Construction Loan Amount
Lenders want you to have more equity in the new home project, greater down payments, or land equity. Gone are the days of sub-prime loans and stated income mortgages. Construction lenders today want to see full documentation and asset-based qualifications. Your employment, credit scores, debt-to-income ratio, and other qualifications will be reviewed. With a maximum debt-to-income ratio of 38 percent, including both the payment on your current home and future loan payments, many homeowners will have to sell their current home in order to qualify for a construction loan.
Your dream of building a new home is not out of reach, but in today's market you must plan, prepare, and make a strong presentation to the construction lender. The market values and construction cost details that you present to the lender will have to meet underwriting guidelines. Be sure they are accurate, and verify all of your qualifications in advance. Make good use of the resources available. Some of the best resources in today's market are local and regional banks. Local banks understand your housing market; develop a relationship with them, and they can help guide you. Valuable online resources are also available. Check out a comprehensive resource which can provide assistance with local construction loan options as well as project planning, construction budgeting, and project management.