How Construction Loans Work When Building a New Home
by Terry Darby
When it comes to getting financing for a home, most people understand basic mortgages because they’re so simple and almost everyone has one. However, construction loans can be a little confusing for someone who has never built a new home before. In the years I’ve been helping people get construction loans to build homes, I’ve learned a lot about how it works, and wanted to share some insight that might help de-mystify the process, and hopefully, encourage you to pursue getting a construction loan to have a new home built yourself. I hope you find this information helpful!
How Construction Loans Work: The Basics
I’ll start by separating construction loans from what I’d call “traditional” loans. A traditional home loan is a mortgage on an existing home, that generally lasts for 30-years at a fixed rate where the borrower makes principal and interest payments for the life of the loan. These mortgages can be obtained through a conventional lender or through special programs like those run by the FHA (Federal Housing Administration) and the VA (Veterans Administration).
In contrast, a construction loan is underwritten to last for only the length of time it takes to construct the home (about 12 months on average), and you are essentially given a line of credit up to a specified limit, and you submit “draw requests” to your lender, and only pay interest as you go. For example, if you have a $400,000 construction loan, you won’t have to start paying anything on it until your builder submits a draw request (perhaps something like $25,000 to start) and then you’ll only pay the interest on the $25,000.
Construction Loans Are Like A Big Credit Card
The best way to think about a construction loan is to compare it to a giant credit card that only lasts until the home is built. At that point, you then get a mortgage for the house you’ve built, which will pay off the balance of your construction loan. There are no prepayment penalties with a construction loan so you can pay off the balance whenever you like, either when it comes due or before then (if you have the means). So in a way, a construction loan has a balloon payment at the end, but your mortgage will pay this loan off.
Interest rates are also calculated differently: with a traditional loan, the lender will sell your loan to investors in the bond market, but with a construction loan, we refer to them as portfolio loans (which means we keep them on our books). We have the freedom to negotiate the right interest rate based on several factors. It’s not like an auto loan where you walk into the bank and look at the rate sheet on the wall that shows today’s interest rate (which could change tomorrow). I have the ability to look at “the big picture” and determine a rate based on many factors, including your credit, financial history, income and project equity.
You Need Both A Construction Loan And A Mortgage
Eventually, after our construction loan has funded your home’s construction, you will need to get a mortgage for the home which will pay off the construction loan. Something people ask me all the time is “do I have to get a mortgage from the same company that provided my construction?” and I’m happy to answer “No.” You have complete freedom in choosing your mortgage company. I finance people for construction loans all the time where I then hand them over another company to do the permanent mortgage.
Conforming vs. Non-Conforming Loans
I think it’s helpful for people to know the difference between “conforming” and “non-conforming” loans. A conforming loan is a mortgage for less than $417,000, while a loan larger than that is a non-conforming (sometimes called “jumbo”) loan. There are differences in the qualification guidelines on these loans. There are a bazillion mortgage companies that can approve you for a conforming loan: finding a lender for a jumbo loan can sometimes be more challenging because the rules are stricter.
One-Step vs Two-Step Construction Loans
There are two different ways to get financed for building a home: A) one-step loans (sometimes called “simple close” loans) and B) two-step loans. Both loans are great products, but it depends on the type of home you’re building. Here are the differences:
One Step Loans: with a one-step construction loan, you are selecting the same lender for both the construction loan and the mortgage, and you fill out all the paperwork for both loans at the same time and when you close on one a one-step loan, you are in effect closing on the construction loan and the permanent loan. I used to do lots of these loans years ago and found that they can be the greatest loan in the world IF you’re absolutely certain on what your home will cost when it’s done, and the exact amount of time it will take to build. For example, a tract home builder that builds 200 homes a year can easily work with a one-step loan when he’s building a floor plan he’s used fifty times in the past. However, when building a custom home where you may not be absolutely sure what the exact price will be, or how long the building process will take, this choice may not be a very good fit.
If you have a one-step loan and later decide “Oh wait, I want to add another bedroom to the third floor,” you’re going to have to pay cash for it right then and there because there’s no wiggle room to increase the loan. Also, as I mentioned, the time line is very important on a one-step loan: if you expect the home to take only 8 months to build (for example), and then construction is delayed for some reason to 9 or 10 months, you’ve got major issues.
Two Step Loans: with a two-step loan, you’re splitting up the construction loan and the mortgage, where you finish building your house and then close on the mortgage when it’s built. This is a much better fit for people building a custom home. You have more flexibility with the final cost of the home and the time line for building. I tell people all the time to expect that changes are going to happen: you’re going to be building your house and you’ll realize halfway through that you want another feature or want to change something. You need the flexibility to be able to make those decisions as they happen.
With a two-step loan, you can make changes (within reason) to the scope of the home and add change orders and you’ll still be able to close on the mortgage. Also, since the clock is not running like on the one-step close, you can take a bit longer to finish building the house. I always give people plenty of time to get their homes built. Delays occur, whether it’s due to bad weather or other unforeseen circumstances. With a two-step, will have the flexibility of extending the construction loan.
Qualification and Down Payments
We look at the same basic criteria when approving people for a construction loan, with a few differences. Unlike the VA loans or some FHA loans where you might be able to get 100% financing and even have nothing down, the maximum LTV (loan-to-value) ratio we generally work with is about 80%. Meaning, if your house is going to have a total price of $650,000, you’re going to need to bring $130,000 cash to the table, or at least have that much in equity somewhere. If you happen to have owned your lot for an extended period of time, we can consider the appraised value of the lot as a contribution toward your equity requirement.
You May (Or May Not) Need To Sell Your Current Home First
One popular question I get is “Do I need to sell my current home before I get a loan to build a new home?” and my answer is always “it depends.” If you’re seeking a construction loan for, let’s say, a $500,000 home and a $250,000 lot, that means you’re looking for $750,000 total. So if you already live in a home that’s paid off, there are no challenges there at all. But if you currently live in a home with a mortgage and owe $250,000 on it, the question is: can you be approved for a total debt load of $1,000,000? As the mortgage guy, I have to make sure that you’re not taking on too much with your debt-to-income ratio.
Some people will sell their current home and rent a house while they’re getting their new home built. Others will be able to live in their current home while building, and they’ll sell that house after the new one is completed. So most of the time, the question is simply whether you sell your current home before or after the new home is built. From my perspective, all a lender really needs to know is “Can the customer make payments on all the loans they take out?”. Everyone’s financial situation is different, so just remember it’s all about whether you can handle the total amount of debt you acquire.
5 Common Misconceptions and Mistakes
There are a few things that a lot of people don’t quite understand when it comes to construction loans, and a few mistakes I see frequently. Here are just a few:
#1) You don’t need to already have land!
Great news: some folks think they already need to own their lot in order to get a loan to build their home, but that’s just not the case! I frequently write construction loans for people that include both the house and the land: it’s all part of the cost of building a house. If you have your land already, that’s great, but you certainly don’t need to.
#2) Don’t think “I’ve been approved, so the bank will take care of me no matter what.“
Sometimes people will get approved for a construction loan, which they get excited about, and in their excitement while designing their home, they forget that they’ve been approved up to a certain limit. For example, I once worked with some clients who we had approved for a construction loan up to $400k, and then they went merrily about designing their home with a builder. I didn’t hear from them for a few months and started wondering what happened, and they eventually came back to me with a totally different set of plans and a different builder, and the total price on that home was about $800k. Apparently, in the process, they forgot to tell me that they’d fired their old builder, and hired a new one, and made all kinds of changes in their home’s design and the scope grew out of control. I wasn’t able to get them financed for the new home because it had doubled in price!
#3) Don’t go on a spending spree after getting qualified.
This is especially important if you have a two-step loan: sometimes people think “I’m qualified for a huge loan!” and they go out and buy a new car. …which can be a big problem, because it changes the ratio of their income and debt, which means if their qualifying ratios were close when obtaining their construction loan, they might not get approved for the mortgage that is needed when the construction loan matures. Don’t make this mistake!
#4) Don’t forget to pay your other bills!
This one may seem extremely obvious, but things happen sometimes that make a bigger impact than you might expect. I once had a client who was halfway through having his house built, and he somehow forgot one payment on his current home’s mortgage. He rectified it relatively quickly, but enough time had passed that his lender reported his late payment to the credit bureaus and when the construction process was completed, he couldn’t get financed for a mortgage because his credit score had dropped so significantly. Even though he had a very large income and had plenty of equity in the deal, his credit rating dropped too sharply for us to get him the mortgage. In his case, I was able to help him by extending his construction loan so he could keep the house long enough for his credit score to bounce back, but it was a major hassle and I can’t always count on the ability to do that. The truth is that mortgage companies really don’t care what “the story” is on why you’re late on a payment—if you go on vacation and forget to pay your mortgage, your credit score is toast.
#5) Make sure you have a contingency for unexpected or unplanned expenses.
I always warn my clients that there will be extra expenses when building a home, and you need to have a way to pay for them. Sometimes these expenses are for issues and problems that come up, like finding rocks when excavating. I remember one client recently that was building near the Broadmoor Bluffs and everything was looking fine until the excavation started, when an enormous boulder the size of a large car was found below the surface. They had to use dynamite to blast it out, and that added about $15,000 to the total cost of the project.
Other times, even if you don’t find surprises when excavating, you may have good reasons for adding to the project’s cost: you may change your mind on some allowance items and would want to get an upgraded flooring material, or you may want to finish more rooms in the basement than you initially planned. Perhaps you come up with good ideas or find some appliances or finishes that are more than you budgeted: not having the money to purchase these items can suck the fun out of building your home. You wouldn’t want to have to say “no” to things just because you didn’t budget for them.
So changes can be either positive things or negative things, but they still need to be paid for, so you want to make sure you have some extra money set aside. Some contracts are written with a contingency built into the budget, or sometimes you may just want to set aside some cash in a savings account.
Final Thoughts: Choosing The Right Contractor
One of the most important things I tell people is to choose your general contractor wisely. That, and don’t attempt to build your own home! One of the worst mistakes you can make is to serve the role of being your own contractor. In my experience, this is the most consistent source of problems: I’ve seen everything from major time delays in the construction process, to cost overruns, to the inability to get subcontractors to the show up on the job site, to issues with the building department regarding proper inspection and code procedures, and more. You definitely want to hire a builder, and make sure it’s a reputable builder.
I’ve worked with Andy Stauffer for a few years, and when his clients come in to see me to get their construction loans, they obviously love working with Andy (and who wouldn’t?). I tell people that picking a builder is like getting married: you’re going to be living with someone for nine months to a year (on average) and you better get along with whoever that person is. Trust is something that’s very important, and you build trust over time, but you need to make sure right away that you enjoy your relationship with your builder from the beginning. I’ve seen some builder/client relationships that are downright adversarial, and that is just no way to build a home.