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.

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.

 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.

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.

Modular homes are built in sections at the vendor’s factory, usually to pre-exisiting plans.  Custom modular homes are possible when the buyer pays additional engineering fees.  Modular homes sections are transported to the site on trucks, and usually removed by a crane that swings it right into place on top of a recently built foundation, or onto other previously installed sections of the structure.  A typical section might be a couple of rooms.  Upgrades and finishes are often installed on site by the contractor who built the foundation and is responsible for the entire job.  Like stick built homes, modular homes conform to all local and state building codes, and once completed, should be indistinguishable from a stick built home.  Appraisers are not expected to use only modular home comps.  Total construction costs are generally significantly lower and construction time shorter for modular homes. 

From a construction lending standpoint, the major implication of modular home construction is the timing of the payments to the modular home vendor.  Modular home dealers typically want a deposit, some money during the manufacturing period, and the rest on delivery.  Construction lenders disburse money in draws subsequent to the work being done.  They want to lend more money when the real estate (real property) is further improved.  Modular sections in the factory or on the truck are personal property.  They become real property when attached to the land through a permanent foundation.  Borrowers using modular construction should have extra liquid reserves to bridge the financing gap.  If they can pay deposits and progress payments out of pocket and be reimbursed at the point when the sections are secured to the foundation, the situation is usually workable.  Negotiations involving the modular home dealer and the construction lender should begin ealy in the process on this issue.  The same timing of payments issue can present itself on stick built kit or log homes as well.

Manufactured homes are also built in a factory.  They travel on wheels attached temporarily to a non-removable steel chassis which is a structural part of the home.  Manufactured homes are only built to federal HUD standards, do not meet local and state building codes, and are restricted by zoning as to where they can be placed.    “Single wide” mobile homes are usually on leased land in mobile home parks and on non-permanent foundations.  They have their own personal property financing structure.   It is possible to obtain a construction loan to put a new “double wide” or “triple wide” on a permanent foundation.  Terms of these construction loans tend to be higher than for other types of construction.

The property should be for a complete house that is neither an under, or over-improvement for the area.  You cannot get a construction loan to take you through the framing stage, thinking that you can do the finish work yourself over a period of time.  You cannot get a construction loan to build the guest house first, thinking you’ll move into it and build the main house later, the same way you could not get a conventional loan to buy, for example, a 3 car garage structure with 800 square feet of guest space above it.  This type of property is an under-improvement and cannot be appraised, and could only be sold to a cash buyer.  If you are the first in your market area to add or build square footage in excess of what is common, you may well find there are no comparable sales for the appraisal.  Existing structures on the property should not be commercial, such as a shop.   The property should be residential in nature and not agricultural.  There are title insurance issues if work has started, but construction loans to finish the work are still possible.

If you are a licensed general contractor who makes your living from job income (not capital gains generated from the sale of spec homes), it appears from the property value and location that the finished house will be owner occupied, and you can document sufficient tax return income working for your own company, owner builder is possible.  Having a GC license but working for someone else is generally not acceptable in this tough construction lending environment.  You’d have to be an “approvable” builder with past “happy homeowners”, vendor references, and a track record with your own company.  Generally, a fixed price contract with a builder is required.  Cost plus contracts and construction supervisor arrangements are rarely allowed in this market.  Construction lending is also back to where it was a decade ago in that the more restrictive of loan-to-cost or loan-to-value calculations is used.  You must have a certain amount of cash in the deal, or equity in the lot.  None of the single close construction lenders still in the business are lending off the appraised value without regard to cost. 

As borrowers, you must be able to fully document adequate income to qualify for the single close construction loan as well as your other obligations.  Your middle credit scores need to be at least 680, and 700 in some circumstances.  More than two years of self employment in the same business in the same market area is required in that at least two years must be reflected on tax returns.  You are not going to be able to blend in the income and liabilities of non-occupant co-borrowers in order to meet debt ratio requirements.  You must have verified reserves (about one half of which should be in non-retirement, liquid accounts) after close of escrow on the construction loan.  Reserve requirement minimums generally vary from 6 to even 12 or more months of the projected PITI (principle, interest, taxes and insurance) based on the locked permanent financing rate.  There can be limits on the number of financed properties, and if a minimum of 30% equity cannot be proven on current rentals or the rental of current principle residence, you may find that actual or market rents will not be used to offset those payments.

“Land loans” is a more general category.  Our vacant land loan is for rural/agricultural acreage with limitations.  That particular program won’t allow a residence on the property, but would allow outbuildings like sheds or barns if not given value.  These properties would be zoned agricultural or agricultural/residential, and also must be buildable (see the program description for other limitations).  Vacant land zoned commercial, industrial, multi-family or property that can be subdivided is very difficult to finance these days.  One reason may well be the fact that to obtain a commercial construction loan or a land development loan is this difficult mortgage market, the land would probably have to be free and clear for the deal to “pencil out”.  Commercial banks then have no motivation to do a vacant land loan, and they don’t want to take back non-income producing property.