BUILD VS. BUY - BLOG SERIES
Since so many of our readers ask us about this topic, we decided to write a blog series!
Step #1 - Buying a Good Lot! (Click to read Step #1)
Step #2 - Getting Your Permits (Click to read Step #2)
Step #3 - Part A: Contractors (Click to read Step #3 Part A)
Step #3 - Part B: Financing <----------------
Step #4 - Let the Building Begin!
Step #5 - Permanent Financing and Moving into your Dream Home
PART B: FINANCING
Financing is not the most glamorous part of the process of building a home but it is indeed the most vital because you MUST have adequate funds to get you over the finish line = pass your final inspection and obtain your CofO (Certificate of Occupancy)
Maybe you haven't spent all of your personal savings on the vacant lot you purchased and all additional money that was spent on the "soft-cost" expenses that you needed to spend to get your permits.
Maybe you have access to funds in a home equity line of credit and/or a business line of credit or maybe a retirement fund.
These can be sources of funding that can either fund your entire construction cost or maybe allow you to reduce the amount you borrow from a lender.
TRADITIONAL FINANCING: CONSTRUCTION LOANS
With this type of lending, the financial institution will likely be willing to lend you 80% of the estimated value your home will have after your home is completely built.
More specifically, your lender will order what is called an "subject to" appraisal where the appraiser will take a look at your detailed and approved construction plans and imagine that your home was already completed and using recent comparable sales information of nearby homes, will come up with an appraised value "subject to" the home being completed.
Let's use some real numbers as an example:
Purchase Price of Vacant Land = $250k
Soft-Costs to get Permits = $100k
Estimated "hard costs" for construction from beginning to end and CofO = $700k
"Subject To" appraised Value of Completed Home = $1.4M
Once your construction loan has been approved, the amount of principal that your lender will lend will be up to 80% of $1.4M appraised value = $1,120,000
Typically, what your lender will require a formal quote from a licensed general contractor showing that the total construction costs will be less than the amount that you are borrowing.
Your lender wants to make sure that there will be adequate funds to complete the project because if the project is not completed, (i.e. your home is not completed with a CofO) then the lender does not have an asset that will cover the risk of lending.
In fact, the lender might want to see a quote from a licensed general contractor that is 10% less than the amount you were approved for so that there is a 10% buffer for anything unexpected that might come up... AND IT WILL!!
With a typical home loan that you might get to purchase a home, the lender "funds" you loan in one lump sum into your escrow account, you add your down payment funds. Viola! Now you have your new home and you start paying interest and principal payments starting the month after you close.
In a construction loan, however, it's much different.
Your construction loan is sort of like a credit card with a credit limit for the amount that you were approved for.
Typically, in a construction loan you are required to make an "interest only payment" only on the amount that you have spent.
For Example, let's go back to the numbers used above and imagine that you were approved for a construction loan in the amount of $1.120M and the interest rate is 5%
No payments are due until you start spending money.
Let's say that you finish the grading and on the contractor's quote that was used for your loan approval, the line item for grading was $30,000. Once the grading is completed and you have passed inspection, the lender will send out a representative to confirm that indeed the grading is completed. They will review the signed inspection card, and then approve the release of the $30k.
If for some reason you don't need the entire $30k, by some miracle the contractor completed the work for less than the original estimate OR you might want to contribute some amount of your own funds, then you can request less than $30k to be approve to be "released".
Once the $30k is released, you now have a balance of $30k on your "credit line" so next month you will need to make a payment of $30k x 5%/12 = $125
Keeping this example going- let's say that two months later the foundation is complete and that was $175,000 on the construction cost estimate.
Now the total amount on your credit line that has been dispersed is up to $205,000 ($30k + $175k = $205k) and next month the amount you need to pay has increased to be $205 x 5%/12 = ~$854
This continues as you go through the process and at each milestone and with each successful inspection you pass, additional funds (per the amount on the contractor's estimate) will be released.
The process of funds being released only after confirmation from a bank representative confirms that the work is actually done and the inspection passed is called "FUND CONTROL".
NOTE: at the time your loan is originally approved, you can request some amount to be released in the beginning and although you will start incurring interest charges from day one, you will have funds that you might need to pay contractors as soon as they complete their work. From my experience, contractors like to get paid asap after their work is done.
The process of FUND CONTROL will create a delay in time from when the contractor has completed their work and when you receive the funds to pay for that work. Most contractors will get very grumpy if they don't get paid right away so unless you have made an agreement that the contractor is willing to wait for FUND CONTROL delays then you probably need to have some source of money (think of it as a "slush fund") that you can draw from for immediate payments and then the FUND CONTROL will replenish when those funds are released to you.
TOO MANY DETAILS??
IS YOUR HEAD READY TO EXPLODE YET!!???
SORRY BUT WE AREN'T DONE JUST YET...
Every time you fund a loan, there are typically fees associated with the process of funding so if you first obtain a construction loan there will be fees associated with funding your construction loan.
After your home is completed, you will want to pay off the principal borrowed for your construction loan with "permanent financing" in the form of a 30-year, fixed-rate, fully-amortized loan of whatever other loan product you might prefer for your long-term permanent financing.
OH, I think I forgot to mention that construction loans are considered to be "short-term" loans and are typically only 12 months to 24 months before they are due to be paid back in full.
So, the idea is that you get your construction loan, build your home, then use funds from another loan (long-term financing) to pay off the construction loan principal and live happily every after in your new dream home!
Keep in mind that when you fund your loan for permanent financing you will PAY ANOTHER SET OF CLOSING COSTS.
THERE'S A BETTER OPTION!
Instead of getting two separate loans (construction loan and then permanent financing) you can request a special type of construction loan that has "AUTOMATIC ROLLOVER INTO PERMANENT FINANCING" and with this type of loan, you only have one loan closing- your construction loan will automatically (and without the need to apply for and be approved a second time) "roll-over" into a permanent loan.
What's great about this option is not only that you avoid the "closing costs" on the second loan but also you will typically lock-in the interest rate on your long-term loan at the time your construction loan is approved.
What's great about this is that if interest rates increase from the time you start your construction until you have your CofO then you are loving it and your interest rate will make you smile and if rates go down then you can always refinance at the lower interest rate - yes there will be the additional closing costs on the new loan but if the interest rates are low enough then it would be worth paying the extra closing costs.
FYI: Not all lenders offer construction loans but the last I checked, US Bank and Wells Fargo offered construction loan products.
STAY TUNED FOR
STEP #4: LET THE BUILDING BEGIN!
Buying or Selling Real Estate?
Contact Us Today!
Real Estate Broker / Animal Lover
Homes Fur All is a 501(c)3 non-profit charity organization dedicated to helping the people and pets of NELA.
The Fitzburgh Realty Team