The process of building a custom home can be daunting the first time a dreamer sets out to realize a lifelong dream. Recent events in the financial sector have made qualifying for home construction financing much more challenging. Qualified borrowers must provide substantial proof of their ability to repay the loan. While the number of details may seem extreme, the prepared borrower will move through the loan qualification process without delay. Each step of the construction loan process must be completed in the right order to prevent surprises later.
Preliminary Decisions
One of the reasons that custom homebuilding seems difficult is that the starting point is difficult to find. Lenders require detailed information about the project prior to entering the construction loan process, but the borrower must know how much money he is qualified to borrow. This circle can stall the project before it gets started.
• Determine location – The perfect place for the custom home must be determined prior to approaching the lender. Even if the land has not been purchased, the lender will require details about the location for the future home.
• Select home builder – Certainty about the firm that will build the home conveys to the lender that the project is legitimate. A reputable builder must be selected early in the construction loan process to assist with the cost estimates for the home. Familiarity with the disbursement system used by the selected builder will alert the lender that the borrower understands the construction process.
• Establish budget – Large down payments are required for the land and the construction loan. If the borrower cannot make a 20 percent down payment, the lender will deny the loan during the pre-qualification stage. Borrowers must prove that the loan is affordable within the current household income.
Select Lender
Local banks might not offer the best deal for a construction loan, and many will not offer residential construction loans. The hunt for an experienced lender can be very time-consuming for the borrower. Even if a willing lender is located, the terms of the construction loan might not be conducive to the project. Another option exists for the borrower who has done their homework about the project.
• Know the loan options – One of the more popular options for construction loans is called the “one time close.” After the construction phase, the loan is rolled into a conventional mortgage under the terms stated in the paperwork. Another option is to secure a short-term loan that will cover the construction phase, and then secure a traditional mortgage when the project is completed. The drawbacks to the latter option are the need to re-qualify for the loan, and the two sets of closing costs.
• Find a loan broker – Since the construction loan market is difficult to navigate, many borrowers are allowing a construction loan broker to find the best possible loan and lender. If the broker is experienced, the borrower can provide important details to the broker and trust him to find the best possible options from reputable lenders.
• Final loan selection – Borrowers must not hesitate to investigate the experience level of the construction lender. If the lender is unwilling to provide details about their previous residential construction loan experience, another lender might be a better match. The Loan to Cost ratio, or LTC, should be provided without unnecessary effort to find the information. This is a cash equity payment on the land, and the borrower must know this information prior to continuing to the next step in the construction loan process. The disbursement system offered by the lender must be stated to allow the borrower to find the right builder. The draw system is the most common disbursement system used for construction loans.
Secure the Right Loan
Since the builder has been selected, he can offer his recommendations concerning the preferred disbursement system for the construction loan. Some lenders will offer contingency clauses and require interest reserve accounts to cover unexpected issues encountered during construction that might cause the costs to rise. Borrowers must understand these terms prior to finalizing the loan.
• Pre-qualify for a loan – This important step can prevent unnecessary expenditures. If the lender is unwilling to approve a loan for the borrower, the project will not proceed. This information must be available prior to signing any agreements with current landowners or builders.
Adjustments to the house plans might be necessary to make the project fit within the budget. Borrowers will know how much money will be approved by the lender. Care must be exercised to avoid large purchases that change the financial status of the borrower until the loan is finalized.
• Submit the loan application – The borrower should submit the loan application to the selected lender only after all of the preliminary steps have been completed. Complete information will expedited the approval process. The following details will be required on the loan application:
o Type of loan
o Amount of the loan
o Location of current residence
o Rent or own current residence
o Social security number
o Current employer
o Detailed list of assets and liabilities
o Current income
o Current real estate portfolio
• Determine the Best Approach to an Interest Rate Lock – Some lenders offer the option of locking in the interest rate to ensure the mortgage costs will be predictable at the time the construction phase is complete. The economic climate is difficult to predict, so the interest rate may be lower at the time the loan is rolled over into the mortgage. An experienced mortgage lender can offer guidance, but the final decision must be made by the borrower.
Builder Contract Follows Loan Approval
Only after the loan is approved should the homebuyer enter into a contract with a builder. The lender will require that the selected builder provide a builder’s package. Inside the package is proof of past projects, financial references, and a line item cost breakdown for the current project. Every phase of the project must be outlined, including the amount of money the builder will receive after the completion of each project phase. All of the parties involved in the project must be named in the builder contract, including: the contractor, owner, architect and subcontractors. Other information in the packet will include the following:
• Responsibilities of each party will be outlined in a clear statement.
• Dates for the commencement and final completion of the home construction. Some builders use an event date rather than an actual date.
• Conditions under which the builder will receive payment for each phase of the project, such as passing inspections.
• Sales tax charges will be stated in this packet when applicable.
• List of materials and line item cost breakdown will be included in the references.
• Change order process for any design changes requested by the owner or required by the builder. Construction loans will include a cost overrun provision to cover changes during the project.
• Details of the architect’s responsibility.
• Signatures of the builder and the borrower.
Tips Concerning Construction Loans
Borrowers should be aware of the differences and similarities between construction loans and the traditional mortgage loan. Lenders hesitate to approve construction loans because of the additional perceived risks associated with construction projects. These differences can affect the decisions that are made during the construction loan process.
• Bond markets, which change continually, determine the interest rates offered on mortgages and construction loans. Quoted interest rates can change in a matter of days, so the cost of the loan might rise or fall.
• Construction loans are difficult to find. Credit ratings and existing equity will be evaluated closely by any lender. Qualifying for a construction loan is more difficult than it has been in years.
• The option to qualify for “stated income loans” has been removed because of the tighter lending guidelines that have been imposed.
• Lien wavers might be required by the lender for each phase of the project. When the builder receives payment for a completed phase, the lien waver is signed. Some builders require the same action by the subcontractors. Every waiver must be returned in a timely manner to allow the next phase to begin.
Final Word
Custom homes are built by dreamers who know that there are more obstacles within the residential construction loan process. Many years of building a strong credit history and healthy savings accounts will assure the lender that the loan can be repaid on time. A team of trusted advisors, including others who have built a custom home, will provide valuable referrals and guidance throughout the construction loan process and building project. Whenever obstacles are encountered, the borrower should keep detailed notes and not attempt to move the obstacle through nonconventional means.
All commitments for land, builder contracts and other major pieces of the project must follow the final approval of the loan. Preliminary actions that include detailed research will prevent mistakes that are expensive. Major expenditures must be postponed until the loan is finalized because the lending institution will run a final set of credit reports immediately prior to approving the loan. Borrowers whose financial picture shifts in the final week before approval risk denial by the lender.