by: Rick Gomez
1. Which construction loans are available and which one should you apply for?
Home loan banking and the internet has changed the mortgage and construction loan industry forever. Today’s construction loan choices include the 30 year fixed, 15 year fixed, 1 year ARM, 3/1 ARM, 5/1 ARM, 7/1 ARM, 10/1 ARM and don’t forget the popular interest only loans.
The construction loan of the past was a short term 1 year loan that the customer would have to refinance into a new loan once the construction was completed.
This two time process cost the customer two sets of closing costs and you would have to re-qualify for the new loan once the home was completed.
The most popular construction loan today is the “One Time Close” but not all are created equal. Just like any product there are the best loans, good loans and downright bad loans.
With today’s technology you now have the ability to obtain a construction loan from the best banks in the country and sign your loan documents at your local title company or escrow office. This benefit allows you to have the most competitive construction loan available.
The loan that you should apply for is simple; ask for the lowest rate, one time close for a specific period of time that you think you’ll be living there.
2. Which lenders/banks have the best construction loans and what do you need to apply?
There are plenty of banks willing to lend money for mortgages, refinancing, home equity loans and every other type of loan. But if you’re planning on building a new home, where do you get the best construction loan with the most competitive pricing?
More importantly what is a good construction loan?
A typical construction loan nowadays is a construction to permanent loan that may or may not allow you to lock-in today’s low interest rates until the home is completed. If you choose a loan that does not allow you to lock in upfront, the interest rate may end up higher along with your monthly payment.
The most important thing when searching for a good construction loan is to find an experienced construction loan specialist that knows which banks are the best.
The best banks can offer you a low rate now, upfront, before you start building your new home.
3. Should you go directly to your local bank or to a loan broker for your loan?
Most banks offer loans, and going to them is like shopping at a Ford dealer. The only thing you can get at the Ford dealer is a Ford. But what if you want choices?
One way to get different choices is to go shopping to every bank in town. Or you can call an experienced construction loan broker who has done all of the homework for you and has direct access to hundreds of banks nationwide.
A broker is a representative for hundreds of banks. Although the broker serves as middle-man, his or her services will not cost you anything extra. That’s because brokers get loans at wholesale rates, and pass them along to their clients at retail prices, just like any other business.
The difference between wholesale and retail is how brokers make money. Therefore, you get the same rate from a broker as if you went directly to the lender yourself.
In Fact, because or their volume, many brokers are able to offer their clients better deals than you can get by talking to the banks on you own.
With an experienced construction loan broker you can shop dozens of the most competitive banks nationwide, work with wholesale pricing and can negotiate on rates and pricing.
4. Should you lock in your construction loan before you start building or let the interest rate float?
If the rates are heading upward, lock. If the rates are stable, relax. If the rates are headed downward, float.
Right now interest rates are at an all time low and can only go up in the near future so make sure your construction loan is locked into today’s best interest rates with the ability to float downward.
Inexperienced loan officers will offer their customers an enticing low adjustable rate during construction without an upfront lock-in and the customer may end up having to lock into higher interest rates when the home is completed.
Or the customer is sold on a higher rate during construction with a float down option after the home is built. Again, the rate could be much higher when the home is completed.
Meanwhile the loan officer has been paid and has moved on to the next loan. The only time you want this type of loan is if it’s the only loan you qualify for.
Most loan officers do not explain this to their customers until it’s too late (Closing).
Always ask. Is the construction loan rate locked upfront or floating during the construction loan period? Then ask, is the rate during the construction loan the same rate when the loan converts into the mortgage period.
5. What experience does your construction loan officer have and does it matter?
When it comes to money its amazing how fast any loan officer becomes an instant expert at construction loans. You must keep in mind that all loan officers are salespeople. Yes, I know they have fancy titles like loan officer or vice president but the title is nothing but a fancy name for loan salesperson.
Loan salespeople usually have one main goal in mind when helping you with your loan request and that is the commission. By the way, the fancy name for commission in the loan business is called a loan fee, points or yield spread premium (YSP).
Now don’t get me wrong, there are a lot of good honest sales people (loan officers) that work very hard at providing you the best service and rates. What’s important is distinguishing the good from the bad.
The following questions allow you to quickly find out if your loan officer is experienced at construction loans.
1. How long have you been doing construction loans? 5 years or more is best.
2. What is the loan to cost (LTC) required for construction loans? This is cash equity such as down payment on land. This can range from 5 to 20%.
3. What is better? The voucher or draw disbursement system and why? Draw is now the most popular because the customer has the control of the money.
If the loan officer (sales person) can answer these questions with no problem then they have passed a pretty good litmus test.
If you really want to throw a curve at them, ask the loan officer if they have ever built a home themselves and what type of construction loan did they get.
If you find a loan officer that has gone through the experience of building a home themselves then the odds are you have found an experienced loan officer.
6. Qualifying for your construction loan, exactly how is it done?
The first thing your loan officer wants to see is your completed loan application. The loan application called the (1003) will tell a story of your financial picture.
The completed loan application will tell the loan officer many things including,
1. What type of loan you want.
2. How much money you need.
3. Your social security number.
4. Your current employers.
5. A list of all you assets (money) and liabilities (bills).
6. How much money you make.
7. How much real estate you own.
Once the loan officer has your loan application in hand they can determine whether you can qualify for a loan.
One of the first items pulled is your credit report. The credit report is going to tell 3 main important things.
1. Show your current credit score. The credit score can range from 500 to 800.
2. Show a complete list of all your monthly liabilities (bills).
3. Show all past credit problems including bankruptcies, foreclosures and late payments.
With this information the loan officer will do an analysis to determine if you can qualify for the loan amount that you’re looking for.
This analysis determines a ratio called the (income to debt ratio) and depending on the banks underwriting guidelines this ratio will usually range from 36% to 45%.
The income to debt ratio is the percentage of monthly debt payments (including your new mortgage payment, taxes and insurance). This ratio should not exceed 36% to 45% of your monthly income.
Some banks will allow you to exceed this ratio if you have an excellent credit history and excellent credit score.
The current and the most popular method of qualifying for a loan today is the stated income loan.
Stated income allows you to qualify without verifying your income on your tax returns, W 2’s or pay stubs. The only thing the bank verifies when applying for a stated income loan is your credit score, liquid assets and that you’re employed.
7. How not to be taken by the oldest trick in the book “Bait and Switch”?
The mortgage lending business is notorious for baiting and switching.
Baiting and Switching is when a loan officer or advertisement offers you one thing and then tries to sells you something else.
Typical signs of baiting and switching are obvious, some basic examples are:
1. Over the phone, you are offered a much lower rate than any other quote and once you’ve sent in your application the rate you were quoted has all of a sudden vanished.
2. You are offered a construction loan with no points and no loan fee’s. What you are not told is that you are paying for it with a higher interest rate and the costs are built into the loan.
3. You are told that you will not have any payments while you’re building. What you’re not told is that all construction loans have this option and it’s called “interest reserves” and the payments are added to the loan amount.
Remember three important facts and you will always be in good shape.
1. If it sounds too good to be true there’s usually a reason.
2. Always get your quote in writing, (ask for a good faith estimate).
3. If you are satisfied with the rate and construction loan program that you are quoted, ask to lock it in upfront.
On the flipside, it is very important to realize that most loan products typically go hand in hand with banking guidelines. These guidelines are provided to loan officers to coincide with the customer’s qualifications.
For example, if you have a very high (FICO) credit score with land free and clear, you have more loan options than the person with a very low (FICO) score and no land equity.
8. Now for the biggest secret of all, ready? All banks have access to the same rates and the only reason everyone ends up with a different rate is directly related to how much your loan officer and bank is going to profit from you.
You should probably read that one again.
Your loan officer gets paid like all sales people either by:
1. Salary plus commission
2. Commission only.
It doesn’t matter if you walk directly into a bank or work with a broker, basically everyone gets paid the same.
If you walk directly into a bank the loan officer most likely gets a basic salary and a percentage of the loan origination fee (points and yield spread premiums). If you work with a broker the broker usually works on a straight commission (points and yield spread premiums).
Becoming a broker allows the loan officer the ability to offer their customers the best loans with the most options.
It always amazes me when I see TV commercials or hear radio commercials advertising $395, zero closing costs. I always wonder if people understand how they can do that.
Ok, here is how it is done.
The inside secret is that in exchange for these low or zero closing costs the lenders will make their profits and cover the costs of the loan by charging you a higher interest rate.
This higher interest rate pays what they call in our industry a (YSP) yield spread premium.
By charging you a higher interest rate over the life of the loan the bank can easily afford the commercials, commissions, payroll, and cover the costs of the loan while still making a profit. Also the service is usually very poor and impersonal.
So the next time you see advertising with no closing costs you will know exactly how they are doing it.
So please remember that there is no such thing as a free lunch in any business. Business wouldn’t be business if there were no profits. The most important thing is that you want the best loan available at a fair price with an experienced loan officer.
9. What are interest reserves and contingency funds doing in your closing costs?
The two things most customers do not factor into the cost of the building their new home are interest reserves and contingency funds.
Interest reserves are added to your loan amount to make the monthly payment on your loan. Yes, you read that correctly, you will not have to make a monthly construction loan payment while your home is being built.
The payments are made from this interest reserve account and no, it’s not free. This reserve is added to your construction loan amount.
Interest reserves were designed for the benefit of the customer. Most people building a new home are either paying rent or have an existing mortgage payment while their home is being built.
The last thing a customer needs is another monthly payment while building. So, banks created the interest reserve account by adding up the estimated interest payments over a 12 month period and add this to the loan amount.
If you do not want interest reserves added to your construction loan amount you can ask to make your own monthly construction loan payment.
Contingency funds are added to the loan amount just in case you need more money to build your new home.
With all good intentions construction loans tend to have cost over runs. The bank adds 5% to 10% of the cost breakdown and adds this amount to the loan amount just in case you have cost over runs or need better appliances.
If you don’t need or use this extra contingency fund then it will not be added to your mortgage upon completion of your new home.
So when you apply for a construction loan ask your loan officer to provide you a copy of the estimated construction loan budget.
The budget is created from your costs and includes every cost within the loan including land balances, closing costs, interest reserves, contingency and bank fees.
10. What is loan to value (LTV) and loan to cost (LTC)? Why it’s probably the most important factor in getting approved for a construction loan besides your income and credit.
Initially most banks are concerned with loan to appraised value (LTV) but banks are really more concerned with how much cash you have in the project (LTC).
If you were buying a home instead of building you would normally have to put 20% of the purchase price as a down payment.
Since you’re building a home your cash equity usually comes in the form of how much cash you put down on your land.
Cash equity is king when applying for a construction loan.
For example, if you bought a $200,000 piece of land and the land is owned free and clear you have a lot of cash equity.
With this much cash equity you will most likely not have to bring in any additional cash.
Or if you bought a piece of land over 12 months ago for $100,000 and its now worth $200,000 the bank will use the current value because you bought it over 12 months ago.
In both cases you have brought $200,000 cash equity to the table.
Now if you just bought a piece of land for $200,000 and you only put down $20,000 most banks will want to see 10% to 20% cash into the total project.
Other qualifying cash equity that can be counted are any pre-paid’s such as plans, grading, permits etc. These pre-paid’s can be used for cash equity or you can be reimbursed from the construction loan at closing.
11. Should you hire a builder or be an owner builder?
Do you really want to be an owner-builder? The goal of being an owner builder is mainly to save money. Some people can save quite a bit of money if done correctly.
Some people are not meant to be owner builder.
Possible problems when acting as owner builder are:
1. Construction cost over runs.
2. The best banks with the best rates require a builder or supervisor.
3. Managing contractors to finish on time or to show up for work.
4. Depleting your personal savings.
5. The need to borrow more money.
6. Loan extension penalties.
7. Being taken by unscrupulous contractors.
8. The need to refinance your construction loan.
I could go on and on about the horror stories I hear from Owner Builders that did not get a construction loan and acted as their owner builder.
If you have never built a home before and absolutely need to act as owner builder please take my advice and hire a reputable builder to supervise you and the building of your new home, for a much smaller fee than their normal fee.
The builder/supervisor will help you with the cost breakdown and manage the subcontracting on an as needed basis. If one of your contractors gets out of hand or you need help of any kind, you can call the supervisor for assistance.
Your job is to make sure you are hiring the right people to complete your home. It can make the difference between happiness and misery.
For those of you that have experience at building homes but do not have a license ask about our owner builder program. To qualify you will need a resume showing your experience.
If you decide on hiring a builder to do everything make sure you hire a reputable builder or supervisor with a good reputation and plenty of references.
Ask your friends if they know a good builder and when you start to hear the same name over and over you know you’ve found a good one. Ask the building inspector for a list of reputable builders.
The most important point is shop around until you find a builder with the most reputable and honest background.
If you pay a little more for an honest and reputable builder or supervisor you will be very thankful before, during and after your home is completed
12. How does your builder determine how much your home will cost to build?
The Estimated Cost Breakdown of your home is probably one of the most important forms in the construction loan package. This is the breakdown of each particular cost of construction of the home. The foundation, lumber, framing, plumbing, heating, electrical, painting, and builder’s profit, etc.
The builder usually completes this form to show you exactly what it will cost to build your new home. The most important thing to remember here is that you do not want to underbid any line item and you do not want to overbid any line item. You want accurate numbers from real bids (not guesses) and a 5% contingency for cost overruns.
Good builders will send out the house plans to their contractors for specific bidding on each main item or can estimate the home themselves. The builder will send one set of plans to the foundation contractor, one set of plans to the framer, one set of plans to the plumber, etc, etc.
When all the numbers come in, the builder will fill out the cost breakdown and come up with a total cost to build your new home.
Bad builders will use the WAG method of estimating the cost of building your new home. The WAG method stands for “Wild Ass Guesses”. This method is the most dangerous since it can lead to under and over bidding.
The last method of bidding is simply to over inflate every single line item on the cost breakdown. This is the most profitable method for the builder and the most expensive to the customer.
This is why you want to find an honest, reputable builder with a good reputation in your community. Once the cost breakdown is completed and you plan on hiring this builder to build you new home you will need to type up a contract. The contract needs to equal the added total of the cost breakdown.
Most builders will provide the contract but make sure you read it carefully and that you add your requirements as well. There are two types of contracts
1. Fixed Contract: This contract is simple and straightforward. Take the total of the cost breakdown and put that fixed number into the contract. The builder will provide a list of responsibilities.
2. Cost plus Contract. This type of contract is usually for large construction loan projects.
A. The customer wants to make a lot of changes to their home as its being built.
B. The construction loan period to build the home is 18 months so construction costs can change drastically. The builder prefers this contract to protect the costs and profits.
13. How does your builder get paid while your home is being built?
There are two methods that banks use to make sure your builder gets paid while building your home.
The Voucher Reimbursement system has been around for quite a while. As usual you’ll have some builders that are very familiar with this method of payment and do not like change.
Most builders are really only concerned with how fast they can be paid and how often they can be paid.
Most banks find that the voucher system is simply too much paperwork to deal with anymore. The builder is given a big book of vouchers that looks like a check book and when they want to get paid or need to pay a contractor they need to fill out a voucher form. This voucher form is a request for payment and as long as the contractor has signed the lien release the bank will pay the amount requested.
The bank will also request an inspection throughout the construction loan to make sure that the work is completed.
The Draw Reimbursement system is becoming the standard for construction loan funding for most banks.
The main difference is that the bank puts the accounting responsibility on you or your contractor. The bank uses your cost breakdown as the guide for the draws. Some banks use specific schedules of 4 to 7 draws based on completed construction milestones, such as foundation or framing.
The draw systems also allow the choice of taking draws on a monthly basis, collecting partial payment for work and material items that have been completed.
I personally prefer the draw reimbursement system because:
1. It requires less work.
2. Provides more control for both the customer and the builder.
3. The funds are wired directly into your bank account.
3. It’s easier to use than the voucher system.
4. Some banks now have online draw requests.
14. What type of construction loan insurance is required and who is required to get it?
The reality of construction loan insurance. There are three types of insurance needed to build. All banks require the first two insurances, course of construction and general liability. Workman’s compensation is only required if your builder has employees.
1. Course of Construction Insurance. This policy is an all risk policy to include, fire, extended coverage, builder’s risk, replacement cost, vandalism and malicious mischief insurance coverage.
2. General Liability Insurance. You or your builder can provide this policy. This policy is a comprehensive general policy or a broad form liability endorsement. The minimum amount of $300,000 for each occurrence is required. If the builder provides the insurance a general policy of $1,000,000 or a broad form liability endorsement is required.
3. Workman’s Compensation Insurance. If your builder owns his own company and has employees that are helping to build your home, workman’s compensation is required.
If the builder simply subcontracts out the work and does not have employees per se, they will need to write a letter acknowledging that they do not have employees and are not required to have WCI.
15. Has your loan officer structured your construction loan properly and why it’s so important?
I get loans all the time from customers that went to another lender or broker and were either turned down or were offered a below average construction loan.
The reason was because the loan was not structured properly before it was sent into the bank. Structuring a loan properly is simply making sure that you match the customer’s loan request to the banks underwriting guidelines.
Recently I received a construction loan request from a customer that was turned down by a large national bank. The loan officer had calculated the income incorrectly and submitted the loan as full documentation.
The customer owned his own business and had a lot of tax deductions on his tax returns. The way banks qualify customers as full documentation is very conservative and the loan was turned down.
We took the loan, found the problems upfront and submitted the loan as stated income.
The customer was approved and built a beautiful home in Rancho Santa Fe CA.
Structuring construction loans for approval is vitally important and is the last thing on most customers’ minds. Each and every time I receive a loan from a customer with a bad loan experience it is always because the loan officer did not specialize in construction loans and did not structure the loan accordingly.
Other common mis-structured loan scenarios include:
1. Low cash equity.
2. Improperly completed appraisal.
3. Unexplained credit derogatory.
4. Income incorrectly calculated.
5. Mismatch of customer loan request to the correct lender.
6. Plain and simple incompetence
The old saying “you get what you pay for” is especially true when obtaining financing in building your new home.