How Construction Loan Draws Work

All bank construction loans disburse money subsequent to the work being done, and interest is charged just on the amount disbursed.  Some private money construction loans charge interest on the entire loan amount from the date of funding, but banks can’t do that.  In the past, there were some construction lenders who would impose a draw system on the borrowers and the builder.  They would say, for example, we have a seven draw system, and here it is.  Each stage like grading and foundation, or framing, had a percentage associated with it.  This method was too rigid, and is generally not used today.

The amount of each draw is based on the specific cost breakdown for that particular build.  The builder completes a portion of the build and requests a draw.  The bank sends out an inspector (usually not a bank employee but someone from their third party fund control vendor).  The inspector confirms that certain line items are done, although they are not typically inspecting the quality of the work.  Draws are then made based on the amounts on the cost breakdown associated with the items that had been completed. 

Start up draws for soft costs are allowed either as a percentage (usually not more than 5% of the total contract amount) or for specific soft cost amounts in the cost breakdown  “Soft costs” can include permits, school fees, and unpaid architectural fees, for example.  Retainage, a method affecting draws wherein 10% of the draw amount is retained until certificate of occupancy, no longer seem to be a part of construction lending.  If the deal is structured such that the lot is free and clear, and the borrower is still bringing more money into the deal, that money would be put into an FDIC insured account at close of escrow, and that would be the first money disbursed as work is done.

Draws can be made to the builder directly, or in some cases, to a joint account the borrower and builder have set up for the build.  Draws are generally not made just to the borrower.  If the builder is not a corporation, they will get a 1099 at year’s end for the contract amount.  No 1099s to corporations.

Do we have to sell our current home to qualify for a construction loan?

Assuming there is no question of occupancy on the new home to be constructed, if you earn enough income to cover the PITI (principle, interest, taxes and insurance) on both homes, the answer is no.  Even if you can’t cover both payments with debt ratios that meet program guidelines, you may still qualify.  Before the mortgage crisis, the most flexible of construction lenders would ignore your current PITI, assuming in those boom times that you’d be able to sell your house.  These days, the best case scenario is being able to use 75% of market rents to offset or partially offset the PITI on your current house (the 25% not counted being for vacancies and expenses).  To use 75% of market rents though, the borrowers must prove at least 30% equity in their current house.  This could be done through an appraisal, or possibly a BPO (Broker Price Opinion Letter). This is a variation of the FNMA (Fannie Mae) “buy and bail” rule, requiring the same proof of 30% equity in one’s current home when future rents are used to help someone trade up and qualify for a new home. 

 The rule was put in place to help insure that borrowers didn’t buy a new home and bail on the one where they may have been “upside down”.  Since most banks underwrite to FNMA guidelines, even though the end loans are not go to end up at FNMA, this “build and bail” rule is pretty standard in today’s post mortgage meltdown era.  In its most restrictive form, it can also be applied to someone’s current rental properties which have little or no equity, even when these appear on tax returns showing stable rental income.  Fortunately there are still construction lenders who will use actual tax return income or losses on existing rental properties, therefore not requiring a construction loan borrower to carry the PITI on all their properties.

Construction Loan Appraisals

For a construction loan, the appraisal is done from the plans and cost breakdown.  To call it a “future value appraisal” is a misnomer in some ways since the comparable sales reflect the current market, and no attempt is made to peek into the future.  The appraised value should reflect what the property would be worth if it existed already and was built as planned.  Comps should be similar in design, appeal, effective age, square footage, amenities, and room count and of course should be in the same market area.  Like with other residential appraisals, the comps should bracket the subject properties from the high and low side in most if not all of these areas.   

There are two additional important areas of discussion on construction loan appraisals, the cost approach and the possibility of the property being and over-improvement for the area.  The cost approach is important because construction loans universally are back to where they were 10 years ago, to the extent that value is the lesser of total cost or the appraised value.  Correspondingly, an 80% loan would be based on the more restrictive of loan-to-cost or loan-to-value calculations.  If the borrower is buying the lot, costs are the purchase price of the lot, plus hard and soft construction costs.  Soft costs include plans, plan check, permits, testing and other fees (school fees for example).  If you already have owned the lot for at least a year, the lot value to be used in the loan-to-cost calculation is the lesser of the purchase price or the current value.  No separate lot appraisal will be done.  In the cost approach section of the construction loan appraisal there are numbers for the “site value”, and “as is value of site improvements”. The sum of these two numbers is what is generally used as the current lot value, although sometimes “as is value of site improvements” gets left out.  If the borrowers have done site improvements such as grading or putting in well and septic, the amounts for this work do not get added to the total cost calculations since they should be reflected in “site value” and “as is value of site improvements.”  Softs costs need to be documented with cancelled checks and invoices, and hard costs will be reflected on a fixed price contract with the builder.  Usually the market approach value is higher than the cost approach total, otherwise the borrower might not even be inclined to proceed.

One instance where costs would likely exceed appraised value (based on market comps) is where the property is an over-improvement for the area.  It is hard to get a construction loan on a property which will end of being one of the largest in the market area, unless the borrower starts with considerable equity.  Borrowers may be paying $200 per square foot for additions when appraisers feel constrained to limit GLA (gross living area) adjustments to $100 per sf or less.  This can result in appraisal issues, as can extensive high end remodels without adding square footage.

Builder Approval

To be an approvable builder, the builder must be a licensed GC in the state where the property is being built.  They must have “happy homeowners” for references, presumably based on jobs similar in scope to the new construction project for which they seek approval.  Vendor and bank references are sometimes required as well.  A credit check is usually done.  IRS liens are one area of concern, since the construction lender doesn’t want the IRS seizing bank accounts and stopping the project.  The builder should have performed the previous work for their own company, not as the superintendent or employee of someone else’s company.  If a builder cannot be approved, most homeowners would not want to use them anyway.