Construction Loan Rates

In general, your construction loan rate will either be the first year of an intermediate ARM like a 2/1, 3/1 or 5/1 ARM, or it will be a prime based rate unrelated to the permanent financing rate.  It you get a 2/1 ARM, for example, the initial rate is fixed 2 years, and then would adjust annually the next 28 years.  The construction period would be 12 months, during which time the loan is interest only on the amount that has been disbursed (not the entire loan amount).  In the case of a 2/1 ARM (adjustable rate mortgage), after 12 months the house would be done (assuming all goes as planned) and the loan will be fixed one more year at the inital rate, and the loan will begin 29 year amortization from that point.  This would be the situation if you got a single close construction loan.

If your loan is only an interim construction loan (not the permanent financing), or if the rate during construction is based on prime plus some margin with a promise of a note modification (without additional documentation) when the house is done, your construction loan rate will not be the same as your permanent loan rate.

California Lot Loan

We can do a lot loan in California for up to 70% of the purchase price of a vacant lot.  The lot should be less than 10 acres, although slightly larger parcels may be acceptable if in a subdivision of similar parcels, and vacant lots of similar size have sold recently in the area.  No structures are allowed on the parcel, even if having virtually no value, or having no value attributed to them.  This would include partially burnt, partially collapsed or partially torn down structures.  These would create both liability and marketability issues (in the case of default) for the lot loan lender.  If the vacant lot has a foundation, this is probably acceptable, particularly if no work was done recently, and it is a slab foundation.  Retaining walls may be allowed as well, depending on the situation.

Refinancing a vacant lot in California is also possible.  We can do 65% to 70% of the current appraised value on a California lot loan refinance.  These are particularly useful if the borrower is not ready to build, but faces a balloon payment on their current lot loan, such as on the many Indymac lot loans that were done.  Lot loans in California are fixed 3 years, and then adjust annually the next 27 years,  so they never have a balloon payment due.

Can we start construction, and then get a construction loan later?

This is a bad idea for many reasons, but sometimes borrowers must start due to the permit process.  If this is the case, and you have to start grading, and maybe have to do the foundation, we would suggest a separate contract with the builder.  Contact a local office of First American, Fidelity or another big title company.  Tell them what you are doing.  Put grading, foundation, retaining walls, and utilities on a separate contract.  Obtain lien releases as instructed by the title company you’re going to use.  Finish work, pay everyone, and get lien releases signed.  File a notice of cessation of work, and expect to wait 30 to 60 days (check with title company) before getting a construction loan to build the house.  The best approach would be don’t go verticle if possible.

Certainly, it is better not to prestart at all.  Don’t even put up a fence or allow a porto-potty to be delivered. You create problems with potential mechanics liens and obtaining title insurance for the construction loan.  You will have even disqualified yourself from dealing with most construction lenders.  Some unwise borrowers have even begun construction, used up most of their reserves, charged up credit cards, and made themselves un-approvable because of credit scores and requirements for liquid reserves after close of escrow.

Lot Loan Refinance

We can do a refinance of a vacant lot on Lot Loan Program #1.  There can be no cashout, so we can only refinance your current balance plus closing costs.  This also means no money for plans, permits or construction on a lot loan refinance, even if you are not walking away with cash.  A cashout refinance of a vacant lot is defined as paying off anything other than your current lien or liens on this lot and closing costs.  If you used an equity line on another property to pay for the lot, or a loan from a relative, you cannot refinance that loan on Lot Loan Program #1.  We may be able to arrange a private money cashout lot loan at higher rates and only to about 40% of value.

We can do a lot loan refinance of your current lot loan up to 65% or 70% of the current appraised value, depending on the loan amount.  Land prices are even more volatile than home prices, so your lot may be worth considerably less than when you bought it.  Appraisals can be difficult because of bank owned parcels selling well below previous sale prices, lack of sales altogether, and a lack a vacant lots in mature urban areas.  Nonetheless, if you are facing a balloon payment such as on an old Indymac lot loan, don’t wait until the last minute.  If your balloon note is due, lenders usually stop accepting payments and start reporting lates.

Contingency Reserve

A contingency is an addition to the cost breakdown, usually based on a percentage of the hard costs, to be used to fund changes during the build.  For example, the borrower decides half way through the build that rather than granite tile, they want granite slab in the kitchen.  They can either pay that out of pocket, or if they have a contingency reserve, that will fund the difference.  The money for changes cannot be shifted from one line item to another.  Historically, some banks have required a contingency reserve.  Currently, a contingency reserve is allowed, but generally not required on all of our construction loan programs.  Even when a contingency is desired, sometimes there is not room in the deal based on loan-to-cost calculations or the loan amounts for which the borrower can qualify.  Program # 4 allows for a cost plus contract (as opposed to fixed price), and in this case does require a contingency.  A contingency reserve may also be required if the borrower will be their own general contractor.  This is possible if one of the borrowers is a GC, they make their living from job income (not capital gains on real estate), and it is clear from the circumstances that they are building their own house and not trying to get cheap spec money.  Contingencies are usually 5 or 10% of the hard construction costs if used.

Interest Reserve Accounts

An interest reserve account is another line item in the cost breakdown that is used to pay interest during the construction period.  A construction loan with an interest reserve account essentially uses borrowed funds to pay interest on itself.  Interest is estimated based on the expected rate during construction, the expected construction period, the loan balance at the beginning, and the final construction loan amount.  It is usually assumed that more money will be disbursed in the early parts of the build rather than linearly throughout construction.  With these parameters, total expected interest can be estimated, and an interest reserve amount can be added to the cost breakdown.

An interest reserve account would make no sense if a borrower is already maxed out on their loan amount either due to income qualifying, loan to cost or loan-to-value calculations.  For example, let’s say the construction loan is $400,000, total costs are $500,000, and the property is appraising for $500,000 (if completed already as planned).  Assume for illustration purposes maximum loan-to-cost of 80%, lot value of $200,000, construction costs of $300,000 and lot loan balance of $100,000.  The borrower here could get a $400,000 loan because they have 20% equity ($100,000) in the lot.  To close escrow, they would have to bring in closing costs since there is no room to roll them into the loan, but everything else would be covered.  Now let’s say interest is estimated to be $11,250 based on an average loan balance of $300,000 during 9 months of construction at 5.0%.  Total costs would now be $511,500 because $11,500 would be added as another line item to the $300,000 cost breakdown.  Since construction loans are based on 80% of the lesser of total costs or appraised value, the maximum loan amount is still $400,000, and the borrower would now have to bring in closing costs plus $11,500 to close escrow, essentially prepaying interest up front rather than getting a bill monthly.  This would make no sense. 

When there is room in the deal to allow for an interest reserve account, interest is charged and disbursed monthly based on average daily balances during the previous month.  You then pay interest on the interest, but if your interest reserve account is $20,000 for example, you are not paying interest on any part of that $20,000 until it is used.  This works the same way as other line items.  If cabinets were $20,000, you wouldn’t be paying interest on that $20,000 until cabinets were installed and that money was part of a draw.  The only difference between these $20,000 line items is that the $20,000 for cabinets would probably be disbursed all at once, whereas a portion of the $20,000 for interest reserve gets disbursed each month.  Partial interest reserve accounts are OK.  You would just begin getting a monthly bill when the money ran out.  Interest reserves are optional.

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.

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