In our area of Eastern Washington (which includes the markets of Leavenworth, Wenatchee, Chelan, Quincy, and Okanogan County), we have a limited supply of available homes for sale, and a lot of people wanting to buy. Also, with only a few exceptions, we don't have the large scale developments that you find in more populated areas where you can go tour model homes and buy ‘Lot # 19 with the Berkshire Model'.
To get the type of home they want, many people must resort to buying some land or a lot and having a custom home built. In reality, most people who come to me for a construction loan don't really want a construction loan. They just want a house, but they can't find what they are looking for. As many people seem to be facing this situation for the first time, I thought I would cover some basics of construction financing. Our typical client is someone from the Puget Sound region who is building a vacation home or retirement home in our area for the sunshine and outdoor recreation or moving over here for the small town lifestyle.
I will describe the general process and end with a list of tips.
A construction loan will either be a purchase loan, to pay for the lot plus the cost of construction, or it will be a re-finance, where we refinance your lot to add the cost of a house. In either case, we base the loan on what the house will be worth when it's completed. To get technical, we actually use the lower of either the future appraised value, or the value of the land plus the cost of construction. Lately, these two values have been fairly close.
Construction loans carry more risk to a lender than a regular mortgage, because if the builder runs away to Mexico, or the borrower defaults, there isn't always a ready buyer for a half-framed house. The lender would have to hire someone to finish the project, and then find a buyer when the house is done. Banks hate to do this, and they almost always lose money in the process. So the construction loans carry a higher interest rate and/or higher fees to offset this risk.
There are two types of construction loans; the most common these days is the ‘All-in-One' type where your construction loan automatically turns into your final mortgage when the home is complete. The other is a straight ‘construction-only' loan that finances the construction, but then has to be paid off or refinanced soon after the home is completed. Banks would love for you to have a loan of 80% or less of the finished value of the home, but most will go up to 90 or 95%. This ratio of loan amount to home value is called LTV (loan-to-value). I have seen some that go to 100%, but you pay in rate and fees for the bank taking on all the risk. If you have equity in the land, that counts towards your required down payment.
Once we figure out how much money you'll need, within the LTV limits, we underwrite the three parts of the loan. We look at 1) What you are building, 2) Who is actually going to build it, and do they know how, and 3) can you afford to make the payments. (When you buy an existing home, we spend 95% of our efforts on analyzing your ability to pay, and then check the appraisal and title to make sure the house really exists, and then call it good).
Part of the ‘what you are building' includes a Cost Breakdown which lists the cost of all the major work items such as excavation, foundation, framing, plumbing, etc. We also get a Materials Specifications list which describes the type of siding, flooring, roofing, countertops, etc. These two items along with the drawings go to the appraiser so he/she can figure out what it will be worth when it's built. We also review the cost breakdown to make sure it sounds reasonable, and to see if any items were left out. We also like to see that you have some contingency for changes that may arise.
Our review of the builder consists of checking with his suppliers/ subcontractors to see if he pays his bills on time. We also check the State of Washington website to see if there are any complaints against the builder.
If everything checks out, and your financials show your ability to make the payments, we approve the loan and print the documents for signing. The signing and recording of the construction loan documents is considered the ‘closing' on the construction loan. At this point we take the bucket of money that you are borrowing and set it aside to distribute as the project progresses.
If you already own the land, we are fine with you beginning construction prior to closing. We just don't issue any funds until after closing.
During construction we inspect the project once a month and issue funds according to the Cost Breakdown. For example, if the rough electrical work is done and there is $5,000 for that line item, we will issue those funds. Typically, the builder will give the bank and the homeowner a Draw Request showing the amount of funds requested that month.
Obviously, as the construction progresses, the total amount drawn grows. You will be charged interest every month on the drawn balance of your loan. These payments can either be made monthly or deferred until the end of construction.
At the end of construction, the County or City building inspector will issue a Certificate of Occupancy which means you can move in. The lender will send in their appraiser to make sure the home is complete. At this point, the last of the funds will be issued to the builder. After this, the loan ‘modifies' and becomes your final mortgage. From this point you will begin paying the full principal and interest payment.
Tips:
•1) In finding a builder, talk to some recent clients and see how he did on staying on time and within budget. Also, I would make sure you like your builder; you are going to be practically married to this person for about 9 months, so make sure he can communicate. Ninety percent of all construction horror stories come from a lack of communication between the builder and homeowner.
•2) Find a community bank in the area where you will be building. The reason I mention this is because I think you will find the rates the same as the big banks, but what you are looking for is a loan officer who will be hands-on for your entire process. Your builder will be happy if there is just one person who originates the loan, does the inspections and disperses the funds. In my experience at the big national banks, the loan officer does not typically handle these tasks, they are all done by people in different departments, and sometimes they are contracted out to other companies.
•3) Visit your project as often as possible. If a change needs to be made, the earlier you figure that out, the less the impact there will be.
Everyone's scenario is a little different, but hopefully this general information will give you a starting point in understanding the process.
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