Construction loans are a bit complicated and confusing. We’re still trying to figure them out after 2 years of planning and into our second application process. I’ve gotten a couple questions about them recently, so I thought I’d write a post with some info that might help others. This is just what we’ve experienced so far and it might not all apply for every situation or location. We recommend you talk to several banks and choose the one that works best for you. Along with your personal financial information, the bank will want your signed contract with your builder, the final budget, and the final house plans when you apply or shortly after.
Before the market crashed, most banks offered construction loans and it was possible to even get 100% financing. Now, hardly any banks offer construction loans and the majority of them require a 20% downpayment. We’ve found a couple that will take 15% down, 1 that will take 10% and a credit union that will take 5% down, but only on non-jumbo loans. By far, the majority want 20%. Regardless, if you put less than 20% down, you will pay Private Mortgage Insurance as part of your monthly payment.
We originally thought that the downpayment percentage was figured off the actual cost or appraisal of the house, but that isn’t the case. Here’s an example:
House cost: $200,000
Land Value: $ 40,000
Let’s say the bank requires 20% down. (For now, just assume the appraisal is equal or greater than the actual cost). 20% of $200k is $40k. If the land is paid for and it’s worth $40k, than you could use it for the downpayment, right? Nope. The bank adds the land value to the house cost which makes 20% even more. So, in this example, you would need 20% of $240,000 which is $48,000. In this case, the difference is “only” $8,000, but the larger the numbers, the larger the difference.
Our problem was that the first appraisal came back low. So, in this example, let’s say the appraisal for the house and land comes back at $150,000. They will finance 20% of the appraised amount since it is lower than the cost, or $120,000. The house is going to cost $200,000, but the bank will only loan $120,000. So, that’s $80,000 that would have to be brought to closing along with the $40,000 that was already paid for the land. If money is still owed on the land, that loan is usually rolled into the construction loan at the beginning.
It used to be common to have 2 closings with a construction loan. One at the beginning for the construction loan itself and one at the end for the final mortgage. The downside to that is you have to pay closing costs twice, but you often had the option of your permanent mortgage being with a different bank than the one you used for the construction loan. Almost every bank we’ve talked to only offers single close construction loans now. There is a closing at the beginning, then you just sign a couple forms at the end of construction to turn it into a regular mortgage. Only 1 set of closing costs to pay and no closing to deal with once the house is done, but the loan stays with the same bank the entire time. The bank we are working with now is the only one we’ve found that does 2 closings, but the second closing is minor (and less expensive) compared to the first. The loan will stay with the same bank throughout and there is no option to get the final mortgage with a different bank. 2.5% closing costs seems to be the average we’ve found. In the above example of $240,000, this would mean having $6,000 to bring to closing.
After the closing, the bank will give you a certain amount of time to finish the house (usually up to 12 months, depending on the project) and a certain number of draws on the loan. If the bank loans you $200,000 to build your house, they may allow 6-8 draws during the construction period. You’ll be given a certain amount up front to start the project. If they give you $40,000 to start, you will start making interest only payments on the $40,000 each month. The bank will send someone out periodically to check on the progress (our current bank does this twice a month). They will not allow you to draw anymore money until the appropriate percentage of work has been completed. Obviously, this is to make sure they don’t give you the full $200,000 and only half the house is done. Once the amount of work relative to the amount of money they’ve given you so far is complete, they will allow you another draw of the $200,000. If they give you another $40,000 (just an example), then you will now be making interest only payments on $80,000. Repeat until the house is done. Once the house is complete and all the money has been drawn, it will convert to a conventional mortgage and you’ll pay principal and interest like normal. I should also note that the interest rate on construction loans is typically higher than a conventional mortgage.