What You Need to Know About How Construction Loans Really Work
The loan process you follow when searching for a construction loan has some similarities to that of obtaining a regular mortgage. You will still be judged on your income, credit, savings and monthly debts just like a regular mortgage.
However, with a construction to permanent loan, there are a few additional factors that lenders consider. Since the home is not yet built, an “as-finished” or “as-completed” value must be established by a “plans and specs” appraisal.
When you go to get a mortgage on an existing house, you will also need an appraisal to establish the value and to insure that you are not paying more for the house than it is worth. With a home that is not yet built, this is doubly important. The lender needs to see what the projected home will be worth based on other homes that are similar in the immediate area.
Basically, for an appraisal prior to construction, you will deliver to your appraiser a set of home plans along with a list of materials you intend to use to finish the home, such as flooring, appliances, countertops, etc. Then, the appraiser will go to the vacant lot upon which you plan to build, and he will determine an appraised market value based on the recent sale of very similar homes in the immediate area.
In addition to the appraisal, the lender will also examine your proposed budget carefully to determine if there is enough money to build the home and if the builder (or owner-builder) is over-spending to build a home of that particular appraised value.
Each lender can have its own set of guidelines and parameters it uses to determine if you are under-budgeting or if you are over-budgeting. But, in general, the lender’s goal is to protect you and themselves from some potential disastrous scenarios: either an unfinished house or an over-built home in a market that won’t support the price.
Therefore, think of your construction loan as requiring two sets of approvals. First, you must be approved as a borrower. Second, the project you wish to build must be approved based on the appraisal and budget.
And, typically, the qualifying guidelines, especially for owner-builders, are more stringent than for regular purchase mortgages. This is for two very simple reasons: risk and supply/demand.
There are thousands of loan programs out there for buying a house. You can have good credit, bad credit, low income, high debt or any number of other variables and still qualify for a purchase mortgage.
But the choices are more limited when building a home. Construction loans (and owner-builder construction loans in particular) are more risky for lenders. This is why not all lenders offer them. And, it is why those who do offer them can set tougher qualifying standards and be more particular about who they give their money to.
Risk, along with supply and demand, determines all mortgage pricing.
Remember that construction loans in general, and owner-builder loans in particular, are more complex than typical purchase mortgages. They will require more time to prepare for on your part.
And, they will take longer for your lender to process and get you to closing than normal. So prepare appropriately. If you understand the process before starting, and set your expectations accordingly, you will have a much more pleasant loan experience.
In fact, when considering the timeline required to close on a construction loan, keep in mind that many times the lender is forced to wait on you, the borrower. Often, the slowest part of construction loan planning involves waiting on the blueprints and the budgeting.
The underwriting of the loan cannot really begin until the blueprints and budget are complete. So, the lender is often forced to wait for the borrower to complete these items. This is not a bad thing. It is just an important point to remember when planning for your overall construction loan timeline.
Speaking of planning for construction loans, here is one last important point that you may not have considered yet. As the mortgage market has drastically changed nationwide over the last couple of years, one of the new mortgage industry catchwords that you will likely hear is “area of declining value.” Chances are you will hear quite a bit about this for the next year or two.
What does it mean if you live in, or want to build in, an “area of declining value?” Simply put, it means that the government has declared that your local area has seen significant enough drops in average home values to place your area on a watch list.
Mortgage lenders have adopted different guidelines for doing business in these areas – and all lenders are slightly different.
Be prepared: if you find yourself in one of these areas, you will likely have a different set of qualifying standards than if you were not in a declining market area. This is not a reflection of you as a borrower, but in the general market conditions that currently exist.
Overall, if you are considering building your home and need construction financing, hopefully this brief article helped you recognize some of the key differences between the simpler purchase loans to which most people are accustomed and the more complex construction to permanent loan that will be required for building your home.
What are the key things to remember? First, understand that the construction to permanent loan is more complicated and may take a bit longer to complete. Second, be aware that there are basically two sets of approvals that are required: your credit approval as a borrower plus the approval of your project’s budget and appraisal. Finally, be on the lookout for areas of declining value, as it might affect your construction loan in some way or another.