Are you in the market for a new home? With the scarcity of inventory in today’s real estate market, many buyers are choosing new construction. If this is your first-time building, you may be wondering how a construction loan works.
It is imperative that buyers work with a Realtor. It is in your best interest to find a buyer’s agent you like and trust before beginning your home search. There is so much more to a build job than picking counter tops and paint colors! Your agent will take on much of the stress for you and will do their best to prevent delays. Add the elements of negotiation, scheduling, inspections, final approval, and weather, and it becomes clear: smart buyers bring their own representation to the table. Plus, most buyer’s agents do not charge a percentage commission for their services. It’s the seller or builder that pays the commission portion at closing.
Construction loan requirements are similar to purchase loans but with a few notable differences. First, the lender will want to know if you already own the lot or if you plan to purchase a lot from your builder. If you own the lot but have a mortgage or other loan for which the land serves as collateral, the lender will take that into account. You may be required to pay-off your lot before a new mortgage can be offered or you may be able to roll the outstanding balance on the lot loan into your new construction mortgage.
It is also possible to purchase a lot on the open market and secure a build contract at the same time, negating the need for a lot loan. In this case, most borrowers would obtain one construction loan prior to the start of their build.
Finally, if you own the land outright (with no liens or mortgages), it can be counted as equity for the purpose of underwriting your construction loan application. In essence, you have already paid for a portion of your new home’s equity.
It is beneficial to have an understanding of basic underwriting requirements. These apply to new construction as well as for the purchase of an existing property.
FHA - In general, FHA guidelines call for a debt-to-income ratio (DTI) of 43% or less and a credit score above 580. Lower credit scores and/or higher DTI’s may be acceptable, but the lender is likely to raise the down payment requirement in these cases. Borrowers without a credit score may be underwritten in accordance with non-traditional credit guidelines.
Conventional – Conventional underwriting guidelines are tighter than FHA. While a DTI of 43% is still acceptable, a credit score of at least 620 is the industry benchmark. For more on Conventional loan requirements, check out the Fannie Mae Eligibility Matrix. The Freddie Mac Seller/Servicer Guide is also a useful guide, but navigating these resources can be time-consuming. For quick answers, get in touch with a Ruoff Loan Expert.
VA – VA lenders usually like to see a lower DTI of 41% or less, but the underwriter does have some discretion here (source: The VA Lender’s Handbook). As with any VA loan, the veteran-borrower must be considered eligible and furnish a Certificate of Eligibility (COE) and present an acceptable credit history.
The appraisal process can be different for a construction loan versus the purchase of an existing property. Expect to pay up to $500 for the appraisal. This could be charged as an upfront cost or rolled into your loan. Your lender can advise on how the appraisal payment should be handled. Following are the basic parts of every appraisal, assuming the appraiser is licensed and used the Uniform Residential Appraisal Report (URAR):
Subject Property – This section comes first on the URAR. The appraiser lists details of the subject property such as the address and recent sale date if any. The appraiser performs a visual inspection to verify that the subject property is in fact at the location named on the purchase agreement.
Contract – This section includes pertinent details from any purchase agreement in effect (if one exists).
Neighborhood – A description of the surrounding neighborhood and relevant statistics appear here.
Site – The site section discusses land, utilities, and easements/encroachments.
Improvements – Improvements refer to features of the subject property, such as flooring.
Sales Comparison Approach – The sales comparison approach is the most common method of valuation. It occupies a substantial section of the URAR. To complete the sales comparison approach, the appraiser finds and assesses comparable properties. Ideally, comparable properties include a mix of active, contingent, and sold properties that are geographically close to the subject.
The comparable properties, also called comparables, help the appraiser determine a value for the subject property. Each property and its features are rated as the same, inferior, or superior to the subject and the value is adjusted accordingly. Many items are assessed in this section. For example, a three-car garage would be rated as superior to a two-car garage.
Cost Approach – The cost approach assumes that a buyer would not pay more for an existing home than they would pay for the cost to construct the same home. Construction loans typically condition for this part of the URAR to be completed. FHA and VA loans may require a value estimate based on the cost approach (in addition to the sales comparison approach).
Planned Unit Development (PUD) Info – PUD’s often have features like recreational facilities and homeowner’s services that could affect the value of the subject property. If this is the case, the appraiser will make any relevant value adjustments.
For New Construction – The appraisal is based on the value of the not-yet-finished project. The appraiser will search for comparable properties that are fully built and recently sold or, if necessary, still listed. The appraiser will probably give preference to comparables under one year old.
A construction draw is a payment made by the lender to the builder or other contractors for the next steps in the build job. The lender will want to see proof that the job is progressing on schedule before releasing more money. Construction loans typically allow for up to five draws.
How do payments work for construction loans? In other words, do you pay on a construction loan while the house is still under construction? Yes, borrowers should expect upfront and intermittent costs throughout the process. Following are some of the costs you can expect prior to closing:
Interest-Only Payments – Construction loans typically call for interest-only payments through the duration of the build job. You will not pay on the principal until your first payment after the loan closes. In essence, you are not really paying on the house until after the loan closes. Your interest-only payments will be smaller at the start of the build and will increase each time a construction draw is made.
Deposit - The builder will probably require a deposit to secure a construction contract, especially if they own the lot and will be selling it to you in a package deal with the house.
Appraisal – As stated above, expect to pay up to $500 for the appraisal. This may be due upfront.
Origination Fee – Origination fees are typically due upfront.
Other Fees – Your lender will advise on other fees and due dates at the time of your application.
Upgrades – If you choose to add upgrades or features during construction (i.e. after your loan has been approved) then you will probably pay out-of-pocket. In this case, the buyer signs a Change Order Form. Seek advice from your Realtor before signing or agreeing to a price.
When you do reach the closing table (congratulations, by the way!) a down payment will be required. If you already own the lot or paid a significant amount as a deposit, you may have already met the down payment requirement for your loan type. If not, expect to bring funds to closing.
Building a house is a big deal. With so many moving parts, plan on lots of paperwork, daily decisions, and constant communication with all parties. It is crucial that you build a team you can trust. Select a Realtor early, get pre-approved, then go shopping for a builder that fits your budget and style.