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How Do Home Construction Loans Work?

Posted by  on Apr 26, 2010
 

Dear Liz,

My wife an I really want to build our dream house now that our kids have moved out. We need to borrow the money to do it but have no idea how construction loans work. What do we need to consider?

Bob and Linda in San Diego

Dear Bob and Linda,

Construction financing for residential property is a lot less available than it use to be. In the past, you could pretty much count on instant equity when you built your home--the finished house was nearly always worth substantially more than it cost to build. But during the housing crisis, it didn't work that way--people borrowed money to build a home with the idea of using a thirty year mortgage (called permanent financing) to pay off the construction loan. Unfortunately, real estate prices tanked, and when the balance on the construction loan exceeded the value of the finished home, borrowers couldn't get permanent financing and many homes were lost to this sort of foreclosure.

Construction Loans Today

Today, lenders are venturing back into construction financing, but they expect you to have perfect credit and a sizable investment in the property. Construction loans differ from regular mortgages in several ways. First, a construction loan is for a limited duration--six months to two years--and then you must repay it. Some products, called construction-to-perm or one-time-close loans, combine the lot, construction, and permanent loans in one. This minimizes title charges and processing hassles.

Getting the Best Mortgage Interest Rate

Construction loans are based on the prime rate, then when the home is built they convert to normal mortgage financing. The rate during the construction period is less important than the rate when the loan rolls over. That said, you probably won't be able to lock your final interest rate until the home is nearly finished. Some lenders do offer special rate locking concessions; ask about this when you shop for a mortgage.

The Interest Reserve Account

You may be able to arrange an interest reserve as part of your construction lending package. Your monthly payments come from this reserve so that you aren't paying for your new home at the same time you're still paying for the mortgage on your current home. The downside is that you are then paying interest on interest.

The Approval Process

Construction loan approval comes in three stages--first, you complete an application and are approved for a loan. If your loan is a Fannie Mae or Freddie Mac mortgage, your application may be underwritten electronically. Your credit and financial position is evaluated and you are told how much you can borrow. Generally, the amount you can borrow is a percentage of either the total cost or the appraised value of the lot plus improvements. Next, the lender evaluates your builder, making sure the company is licensed and solvent. Many lenders have lists of already-approved builders; by using one you can speed up the process a bit. Finally, your builder submits plans, specifications, and descriptions of materials. An appraiser evaluates the project and comes up with a finished value. The lender lets you know how much you qualify to borrow based on the future value of the home.

Building Your New Home

Your builder gets paid at varying intervals during the construction process. These payments are released on the completion of agree-upon stages of building, inspection at each stage, and a title company certifying that no mechanics' liens have been filed. You can request a voucher control system, meaning that your builder is not paid until you sign off and release the money.

Completing the Project

When the construction is complete, the home is inspected, you get a Certificate of Occupancy, meaning that it's safe to move in, and the appraiser completes a form called a 442, Appraisal Update and/or Completion Report. All subcontractors must release any claims before your loan converts. The lender releases a final draw to the builder and your construction loan is converted to permanent mortgage financing.

 



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