Construction Loan: How to Build a Home – Step 7
The construction loan is the seventh step in our blog series, How to Build a Home. At this point you’ve determined your overall budget, selected a lot and house plan, analyzed your estimated rough costs to build, and now you’re ready to put together the construction loan to build your dream home.
Your Credit Score
When talking to lenders, the first hurdle you will come to will be your credit score and credit history. If you don’t have stellar credit, don’t waste your time talking to the banks. The reason being, even if you can get a construction loan to build a new home, a mediocre credit score will increase your borrowing costs. If your credit score goes down by just 100 points, your loan rate can go up two percent or more. So, be sure to get your credit in order prior to going after your construction loan.
The interest rate on a construction loan for an owner builder is typically in the seven to nine percent range. If you have a builder managing the process for you, the rates can be slightly lower due to the reduction in risk. These rates may seem pretty steep considering mortgages are so cheap these days.
So why are you paying such a premium for the construction loan? It’s really about the risk associated with construction loans. If you don’t finish the job and leave someone else to clean up the mess, there could be considerable costs to the lender. This potential exists however with or without a professional general contractor at the helm. But because a general contractor has experience and a track record, you will have an easier time getting a loan if you use one.
Don’t forget, you will be paying interest only on the money you have drawn on the loan. So, as your schedule progresses, you will only pay on the work that has been completed. And typically, your contracts will give you a fifteen to thirty day grace period after work completion (or delivery of materials) to pay your subcontractors. So, you will have some float time after work is completed to make payment.
Typical fees for owner builder loans include loan origination fees, underwriting and document preparation fees, as well as the closing costs. The total loan fees when you build your own home typically range in the 4-5% range (of the total loan amount). So, as a simple example, if your home and lot together will cost $100k, your fees will be somewhere in the neighborhood of $4000-$5000. One reason for the rather high cost is the short term of the loan. Everyone involved has a lot of work to do to put this loan together. And typically, the money is paid back relatively quickly…within nine to twelve months.
Cash and Owner Equity
In most cases you will need 25% to 30% equity or cash to start your new home project. If you own the lot or land, your equity value is typically included in this calculation. So, let’s say you own a lot (free and clear) that you intend to build your home on and its appraised value is $25k. The value of the lot will fulfill the 25% equity requirement if the total cost to build the home is $75,000 or less and the market value of home and lot together when finished will be $100k or more.
Appraisals are Key
The appraised value of the lot before construction and the appraised value of the lot and home package when completed will have a huge impact on your construction loan. There has been a lot of discussion since the real estate market downturn about the appraisal process. Unfortunately, they have gotten to the point where financing even a traditional home purchase can be difficult because it’s so hard to find similar quality properties that have recently sold. It can be even more difficult when trying to find lots and land to compare to that have recently sold. So, keep this in mind when beginning the process to obtain a construction loan.
Most lenders require inspections to be performed to make sure the actual work is progressing as you build your home. The bank doesn’t want to get into a situation where you draw money on work that is not yet completed. This can cause problems for both you and the lender. As long as the money is being put into the home and increasing it’s value, the lender has some protection if things go wrong. The frequency of inspections are typically after a few budget line items…or sometimes after every draw…it really depends on the company lending the money.
Tips from a Builder
- The Schedule is Key: Once you start construction, the work should proceed as quickly as possible in a quality fashion. Every day that goes by, you are paying 7-9% interest on the money you have drawn from the bank. The faster your schedule progresses, the lower your overall loan costs will be. Also, most construction loans are setup with a maximum term of nine months…so there is no time to waste.
- Build up your credit: Don’t try to build a new home if your finances aren’t on solid ground. Having great credit will lower your borrowing costs and give you piece of mind.
- Contingency: As a builder, I always include in my budget a contingency for any new homes I build. This is money that is used in the event one of my budgeted line items is off. The contingency budget is for cost over runs from unexpected things like weather, poor soil conditions,…etc. so don’t be tempted to spend it unless absolutely necessary.
- Check out construction to permanent loans. These can be more affordable in some cases since you only pay closing costs once.
- Lot/Loan packages: Wrapping your loan for the lot and construction of the home into one can simplify things in some cases. You will still need to meet minimum equity requirements but it can make the process easier.