Banks are averse to risk. This means that when they loan money they typically want collateral to make sure that if they aren’t paid back that they have some type of asset that they can sell and attempt to recoup their losses. In some cases, it is the reputation of the borrower. If the collateral isn’t enough, then a borrower’s credit history of making regular and timely payments plays into the decision of making the loan. A construction loan is unique. A lender is loaning money on something that isn’t done or complete. The lack of a finished asset (house) means risk – which means only specific lenders with the knowledge and skills to do constructions loans offer them.
WHY IS A CONSTRUCTION LOAN DIFFERENT FROM CONVENTIONAL MORTGAGE?
Most home buyers are familiar with a 30 year or 15 year fixed rate mortgage. A mortgage is a loan that a lender provides to finance the purchase of a home. The home acts as collateral in exchange for the money you are borrowing to finance the mortgage for the home. The loan is made for a finished home that is ready to be moved in to. The proceeds of the loan are typically disbursed (paid) to the seller at a closing or settlement. A mortgage payment is composed of four parts: principal, interest, taxes, and insurance. It is typically paid on a monthly basis.
Construction loans are loans that are made to the home buyer for the purpose of building a new home. A construction loan is short-term and converts to a permanent loan once construction is completed. Construction loans are typically disbursed in a process called draws. As work is done on the construction of a home, draws are made to pay subcontractors for work completed. For example, the home’s foundation is completed and so the foundation company is paid for the completed work with a disbursement from a lender that is providing the construction loan. A construction loan payment is composed of only one part: interest only payments on the balance disbursed. It is usually paid on a monthly basis
IS A CONSTRUCTION LOAN RISKIER FOR A LENDER?
When you buy an existing home, whether new or used, it actually exists. It is ready to be lived in. If you would borrow the money and not be able to make the payments to the lender, they then have an asset that they can sell to try and recoup the amount owed. When you are building a home, that isn’t the case. There is no home on the land for collateral.
A construction loan comes with more risk to a lender because they are lending on something that doesn’t exist… yet. Without an asset in place, the bank is lending money on the promise that a home will be built and at the end of the construction process they will have collateral. But what if something happens along the way and the home isn’t completed?
This means risk for a lender. A risk that they may not be paid back if the home under construction isn’t completed. Lenders deal with risk in several ways:
- Higher interest rate – A bank believes they should have a higher return if they take a higher risk. Construction loans typically have a 1% higher interest rate than a 30 year mortgage.
- Higher credit score for borrower – If they don’t have an asset as collateral, then they depend on the credit reputation of the borrower. This means a higher credit score is needed for a construction loan.
- Higher down payment – Construction loans may have higher down payment requirements. The lenders view is that if the borrower has more at risk, they too will work harder to make sure the construction is completed so that the construction can be paid off with its conversion to a conventional mortgage.
- Higher fees – Lenders will charge points. Each point equals 1% of the loan amount. A lender will charge an interest rate for the loan and may charge additional fees known as points to increase their income from the loan.
- Tighter Lending Requirements – Lenders will do it anyway, but with construction loans, all of the paperwork must be in order. The lender will only make the loan if everything is insured, borrowers meet strict verified income requirements, and proper insurances are in place.
SO, WHAT CREDIT SCORE IS NEEDED FOR A CONSTRUCTION LOAN?
If a home under construction isn’t completed, the lender is in a bind. Why, because no one wants to buy a house that is half finished? If it is a house built on site, how long has it set out exposed to the weather? Did the contractors and subcontractors get paid? What is the quality of the home if sub-contractors weren’t paid and no one came back to service any issues. All of these items make it very difficult to sell a home that isn’t completed.
It is all about risk with a lender. A lender would rather take a lower interest rate loan and have a lower risk borrower because they know they will get the funds they loaned to the borrower back based on their past history. This means the higher your credit score the better your chances are of getting approved for the loan. It also means you may pay a lower interest rate. If you are building a home you should aim for a minimum 680 credit score. A better minimum score is 700 -720 to qualify for a construction loan. It is possible to get a loan with a lower score but there must be specific mitigating circumstances. One of them is a higher down payment.
TWO SCORING SYSTEMS: FICO SCORE AND VANTAGESCORE
The Fair Isaac Corporation (FICO) is the dominant scoring system that became the industry standard for lenders making prescreened credit offers, approving or denying applications for new credit, and managing their existing credit accounts. It is still the major score (or a variation of it) used my mortgage or construction loans lenders when evaluating borrowers and most likely that his the score you need to care about and focus on.
An important model that is gaining on FICO for credit scoring is VantageScore. It is a credit scoring model that first emerged in 2006 as a joint venture of the big three credit bureaus — Experian, Equifax and TransUnion. It is the score you are typically being shown if you have a credit card that provides free credit scores and is also the one displayed by Credit Karma, a popular credit knowledge site on the web.
HOW CAN I IMPROVE MY CREDIT SCORE?
If you don’t have a 680 credit score there are many things you can do to improve it! First, get a copy of your credit report. That shows you the building blocks of what impacts your score. You are entitled to one free copy of your credit report every 12 months from each of the three nationwide credit reporting companies. You can order them online from annualcreditreport.com, who is the only authorized website for free credit reports, or call 1-877-322-8228. Review for errors and get any fixed. The FTC says that 21% of all credit reports have confirmed material errors. These errors, left unfixed, could be the difference in building a home or not.
Here are 5 basic items you need to do raise you credit score:
- Keep credit card balances below 30% of available credit
- Eliminate credit card balances altogether
- Leave old debt on your report
- Use your credit
- Pay your bills on time
CONSTRUCTION LOANS AND NEW HOME CONSTRUCTION
When you decide it is time to build your new home and you know you will need to finance it, don’t wait. The very first place you should go is to a construction loan lender and get qualified for a loan. It is important to know if you qualify, and how much you qualify for, before you ever start looking at home plans.
Modular Homes are treated just like a conventional site built homes for conventional 30 year or 15 year mortgages. However, there are some slight differences in when it comes to how the construction loan works for modular homes. Modular construction takes the big bang approach. Onsite a modular home shows up about 75-80% complete because it was built offsite. With conventional construction, some work gets done, the lender inspects it, and the lender pays for the work completed. Modular homes are less risky to build. Because a modular home is typically completed more quickly on site leaving less of a chance for something to go wrong. Even if it does, the home is set and protected and substantially complete. Modular homes reduce the risk for construction loan lenders.