Construction Loans? When And Why To Use Them

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Why use a Construction Loan?

Building your dream home or rehabbing your investment properties, though exciting, may present many challenges. Although you may be familiar with the traditional mortgage process, a construction loan includes additional elements of risk. In a typical construction project, the contractor will request funds when work is completed. Many times a homeowner will build their dream home without the use of financial institution funds. There are various ways to pay your contractor, many people feel they should pay cash, use a home equity line of credit from another property or cash out an investment.

This presents unique challenges for the homeowner. The homeowner must manage the additional responsibility of ensuring all subcontractors and suppliers are paid in a timely fashion. The homeowner must also understand the statutory documentation requirements in their state. If the draw process is not properly managed and the contractor does not pay the subcontractors and suppliers, the homeowner may be subject to mechanics liens. To mitigate your risk throughout the fund control process, consider the benefits of a construction loan and the process. The construction process is a complicated one and the construction draw process will ensure all subcontractors and suppliers are paid so that you don’t have to pay the bill twice.

A construction loan is a check and balance of the funds that are dispersed throughout the build of a new home. With the help of the lender(s), inspectors and draw processing staff your funds are reasonable protected.

Understanding the Costs Involved
As you begin the process of building a new home, you’ll want to understand the costs associated with your construction and permanent loans. You’ll also need to know when the expenses occur so that you can prepare an accurate budget.

  • You can begin construction with as little as a 10% down payment or 10% equity in the total cost to acquire your lot and build your new home. If you don’t own your lot, the first draw of your construction loan may be used to pay off your lot. There are instances that a borrower will not be required to have any money down.
  • The interest rate on your construction loan is typically tied to the Prime Rate. You will be billed monthly for interest only, and your payments will be based on the current balance of it at the current interest rate for the previous 30 days. Borrowers can build in an interest reserve account to pay the interest payment during construction.
  • When you finish building your new home, we will modify your construction loan to a permanent loan of your choice. Various options for locking in your rate are available depending on the product selected.

Total Project Costs
This is the cost to complete the home and consists of soft costs, hard costs, land value, closing costs, contingency and interest reserves.

  • Soft costs: Permit fees, engineering fees, architectural fees and other costs associated with building the home but not directly a part of the actual construction costs. Many times the borrower has already paid some of these costs. To consider these paid items as “equity,” the borrower must document the cost with a bill and a canceled check or a paid receipt.
  • Hard costs: The actual cost of construction covering all materials and labor associated with the building of the home. Typically the borrower will enter into a contract with a contractor to build the property. Like a purchase contract for an existing home, this contract will set forth the work to be done and the costs associated with that work. All contracts must be for a fixed price; “Cost Plus” contracts are not acceptable. To support this cost, we require a signed and dated copy of the contract along with a detailed Line Item Cost Breakdown prepared by the contractor. All contracts and budgets must be reviewed by, and contain terms acceptable, to standard lending guidelines.
  • Closing Costs: Costs associated with the closing of the loan (e.g., title costs, loan fees, discount fees, inspection fees, appraisals, etc.)
  • Contingency: In certain circumstances a reserve account will be needed to cover unforeseen cost overruns in the construction of the home. A required 5% of the hard costs will be established in the Contingency Account (Contractors may hold a reserve other than what usually required by the Lender.)
  • Interest Reserve: At loan closing, an account is established to pay the estimated interest costs during the construction of the home. Since the borrower is only charged interest on the amount of funds disbursed, an estimate of the average disbursed amount is made. Our construction specialists will estimate that, on average, 60% of the loan amount will be disbursed during the term of the construction period. This interest reserve account is paid up front and is held to pay the interest during the time of construction.

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  1. The draw process is a good first step. As part of the payment process, demand partial and then final releases of lien with each payment. This is really the only way to protect yourself. Just making payments when the work is actually done, won’t do it.

  2. This is exactly the way that many development companies do things, so surely if you are a self builder you may as well follow their example, they will understand the industry and financing of it better than you or I could even with days and days of research. They basiclly already know what works!

  3. Also 99% of loan closings should have a certified, insured and bonded notary signing agent. This is different from a general notary. I’m the CEO of a well known mobile Texas signing agent firm in Austin, TX sp I’ve seen a lot of the bad side when people don’t get all documents notarized.

    The $125-$150 which is a typical national fee, it a small price to pay to protect all parties involved.

    Nice artice by the way Troy.

  4. Alison Moore Smith on

    We are building our second custom home. Getting a construction loan these days is nothing like it was in 2003. This time (last fall) it was a months-long nightmare. We owned a $250k lot free and clear. We have excellent credit. Doesn’t matter. All the comps in our area since last April were short sales. Read that: banks won’t lend even close the the materials/labor costs in this area.

    We ended up having to come up with a boatload of cash just to get this going.

    We did a one-time close, particularly because we were very unsure if the rates would sky rocket in the coming months.

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