Key Points in Construction LendingBy James P. Anzano, President, Van Dyk Home Loans a Glendenning Mortgage Corporation
Construction loans are a somewhat scarce loan product as most lenders prefer not to take the risks not only related to borrower issues (which are taken on every loan) but also risks related to the project and the builder. Should anything go wrong during construction, a lender may be left with an unfinished house that was being built to one owner’s tastes and therefore is a fairly illiquid asset. After all, how many people want to buy a house which is mid-construction, exposed to the elements, and designed by someone else.
As a result, the number of lenders offering this loan product are few. Those that do often are interested in fairly conservative projects in terms of credit profile, builder track record, etc. Below are some key points to consider in considering a construction loan:
[1] Is there any other way to finance this construction? – We always attempt to identify any other means of obtaining the funds needed to buy land and build a home as the construction loan process is time-consuming, expensive as compared with traditional mortgage products, and involves draw administration post-closing including multiple title updates and property inspections during construction. Other sources of funding include loans against other real estate and loans secured by investment assets.
[2] Lending against “As Complete Value” vs Project Cost – Most lenders offering a construction loan today will lend against the “As Completed Value” of the home vs. the actual project costs. Also, if the land has already been owned for more than 12 months, usually the fair market value of the land less any existing debt can be used as equity. Borrowing against the “As Complete Value” will typically allow a borrower to finance most, if not all, of the money needed to complete the project.
[3] One-Time Close vs Two-Time Close – Our firm offers a 2-time close product whereby you apply for 2 loans initially, a construction loan to close now and a permanent loan to close when construction is completed to pay off the construction loan. A 1-time close product is a combination of the 2. Each has its pros and cons but the end result is fairly similar.
[4] Reserves for Interest and Construction Contingencies – Many construction loans require a reserve to be established for estimated interest charges during construction so that borrowers do not have to make payments during construction and a construction contingency reserve to allow for change orders, upgrades and other cost overruns during construction.
[5] Draw Administration – Unlike most mortgages that require little contact between a borrower and lender after closing, a construction loan requires a close working relationship between borrower and lender during construction to administer draws, order inspections, process change orders, etc. Therefore, it is important to understand where this process takes place and by whom after closing.
As you can see, there are many important issues to understand when considering applying for a construction loan to finance the building of your new home. Although the process may seem complicated and costly, the end result should hopefully justify the means when you move into your new, custom-built home!
