Most of us in this industry are used to the traditional 30 year fixed loans regardless if it’s FHA, VA, USDA or Conventional. Many lenders can offer these types of loans and most of the time the loan products, interest rates and qualifying factors will be the same with a few varying factors such as down payment requirement, credit score, etc. Most real estate agents pick the loan officer or Mortgage Company based on their ability to “get the job done”, their availability and their “bedside manner” (so to speak) more than the actual loan products they provide. However, construction loans are different. Many lenders will not finance the land or the build but would be happy to finance the completed product so in these situations the margin of useable lenders slims dramatically. Knowing what lenders can finance land and construction products could be the difference between getting a deal and losing a deal to a real estate agent that works directly for the builder. It’s good to ask your three preferred lenders which one can do these type of transactions and if none of them can do it then it is time to start interviewing for a forth lender that you can trust your clients with.
What is the difference between a Construction Loan vs. a Traditional 30 year Loan?
First off, I am considering a traditional loan to be a 30 year, fixed rate loan on an existing property where the client can pay principal and interest payments monthly for the life of the loan. These loans can be FHA, VA, USDA or Conventional products. These loans are fully funded in one lump sum at closing when paperwork and signatures are exchanged.
In comparison, a construction loan is underwritten to last for a much shorter period of time, usually 12 months on average. It is only supposed to last as long as it takes to complete the construction of the home and after that point permanent financing is required. A construction loan is like a line of credit, or a credit card basically with a much lower interest rate. You are given this line of credit up to a specified limit and you will submit “draw requests” to your lender. You only pay as you go.
So an example would be if your client was building a $300,000 home but they won’t start paying the interest on the full $300,000 loan right away. Their builder will requests draws from their lender usually around $25,000 to start (this amount can be different depending on the builder’s needs), then they will only start paying interest on the draw amount. For this example if the lender requests $25,000 up front then your client will only pay interest on that amount until the builder requests more funds, such as an additional $25,000. Now your client is paying interest on $50,000.
What happens after the home is built?
Once the construction is finished and all the draws on the loan have been made, your client will need permanent financing on the home. Most construction loans are set up so that after the home is completed the lump sum is due as a large balloon payment. So, if we go back to the example above, your client will need to now pay the $300,000. Your client will then apply for a traditional mortgage aka 30 year, fixed, principal and interest payments monthly, either FHA, VA, USDA or Conventional products and we are now back to familiar territory.
One thing to note is that construction loans usually do not have a prepayment penalty so if your client has the means, wins the lottery or gets a large inheritance before completion of the home and decides to pay off the construction loan in one lump sum they can do so. However, most people use a traditional mortgage to pay off the final lump sum payment.
A few other things to consider with construction loans are this, interest rates will be different than your traditional mortgage and are often times higher due to what the lender perceives as risk and your client does not need to use the same lender that did their construction loan for their final permanent financing. They have the freedom to shop around and look for the best deal or best person to work with. Also, if their final home amount is considered jumbo sized, they will have even fewer lenders to choose from as well. Many lenders do not offer jumbo loan products or their jumbo loan products are not competitive against larger banks or mortgage companies that can keep the cost lower. So if the home price is over $424,100 (this varies state by state and county by county) then you may want to give the clients a heads to start interviewing lenders for their permanent financing way ahead of time so that when their lump sum is due they are ready to go.
“One Step” Loans vs “Two Step” Loans
A “One Step” Loan is when the client choses to have the same lender do the construction loan and the mortgage. They will fill out paperwork for both at the same time and close for both the construction loan and the mortgage. A “One Step” Loan can be the best product IF your client knows exactly how much the home is going to cost and the exact amount of time construction will be completed by. “One Step” Loan products are used often by a tract home builder that does 50 plus homes with the same layout and can give you a precise timeline of construction completion. However, if along the way the buyer wants to add a room or a garage and added expense is needed the client needs to be aware that they will have to pay out of pocket for this as the cost was not built into the loan. Basically they will need cash reserves if they change their mind at all during the project and want something added or upgraded. This is not always a good option for a custom home though because the timeline and cost can vary during the project. If your client is building a custom home and they are sure of the completion date and cost then a “One Step” may be a good fit. They really need to sit down with the builder and go over every detail before they make this choice. Just know that if your client’s home is supposed to take only 8 months to build and it gets extended for another month or two this will cause major issues.
A “Two Step” Loan is more forgiving and flexible to home build plan changes because you are splitting the construction loan and the mortgage loan in two. Your client will not have such a strict timeline or inability to make changes (within reason) as they seem fit during the build. Once they finish the build then they will close on the mortgage so it gives the client a slightly more forgiving timeline as well as a more flexible budget to spend on the final cost of the build. Anything can happen when building and delays are more the norm than not. Weather plays a major factor in this is you live in an area that does not have beautiful sunny days 365 days a year. Always expect the unexpected because unforeseen issues will arise in almost 99.9% of builds. Proper expectations should be set firmly in place when your clients begin the construction process. You can hire the best builder out there but some things will be out of his or her control, so be prepared for this, especially when building a custom home. A “Two Step” Loan program gives you more flexibility if you need to extend the timeline of the build. I wanted to make sure that sinks in because closing once on both loans in one process may seem very convenient for a buyer but it is not always the best route to take.
Qualifications and Down Payment
This will depend on who you chose to do your construction loan with but the norm is usually you will need about 20% down. For example if we continue to use our $300,000 example the client will need about $60,000 in a down payment. This can be cash in the bank, equity, and/or other assets or held in a retirement account such as a 401k. This money will need to be sourced and cannot just be pulled out of thin air like mattress money. If the client has owned their land for some time many lenders can use the appraised value of the land as part of their contribution requirement. However some 100% financing and low down payment options may be available with FHA or VA products in your area but please note that these type of loan programs are rare in the lending world. Most lenders will not offer this option. Your client may have to do some research if they do not have the 20% required down payment.
Need more information? Please contact me and I would be happy to pass on what I know about the construction home loan process. Please remember that every company has different programs. If one lender cannot help a client another maybe able to. Our goal should be the same and that is get more people approved and into their dream home.