A Nipomo Homeowner’s Guide to Financing Your New Home Construction
Everything you need to know about getting a construction loan in 2023
If you are considering having a new home custom-built for you, you’ll want to read this blog before making any decisions. The process to apply for and obtain a construction loan is not a simple, straightforward thing. Let’s discuss.
Some Basics to Understand First
Construction loans are based on a loan-to-cost ratio (LTC), unlike conventional loans that are a loan-to-value ratio. This means that your loan is based on the cost of the land, the utilities, the plans, the permits, and the build itself. It does not matter if your appraised value of the future home is worth more than these costs.
Construction loans are typically short-term, variable rate loans, with a higher down payment requirement than conventional loans, due to the risky nature of construction loans. They are also much more difficult to acquire than conventional loans as they require a higher net worth and/or guarantee than conventional loans.
Construction loans are set up on a draw schedule. You don’t get the full amount at one time. And if you financed the purchase of the land, and are still paying it off, the first draw of your construction loan will be used to pay off the loan for the land. However, you do only acquire interest on what has already been drawn, not the full loan amount.
Acquiring the Land
You are going to need someplace to build your new home. There are three main ways to go about getting this land: First is purchasing an empty lot. Second is purchasing a lot with a home that needs some serious TLC, to the point that it makes more sense to tear it down. And third is using the land the home you currently are living in is built on. (Or, bonus fourth way is to inherit property.)
If you are purchasing the land, how are you planning to finance that? Are you paying out of pocket or are you getting a loan? Loans for empty lots are difficult to acquire, due to the risky nature of the investment. A property will always hold more value when there are buildings and utilities available on it.
It’s incredibly difficult to add purchase of the land into your construction loan, for a variety of reasons, particularly how long the closing period is on a construction loan.
If you financed the purchase of the property, your lender is going to be very eager to move that loan into a construction loan, and ultimately into a mortgage.
If you already own the land, you’ll need to factor in how long you’ve owned it and whether or not it’s fully paid off yet into your construction loan details. With most lenders, if you’ve owned the property for less than one year, its value to the construction loan is only what you paid for it. Whereas, if you’ve owned the property for more than a year, your lender will have the land appraised, and you will get the current market value of the property factored into your purchase price. This will be beneficial to your down payment requirements.
Acquiring the Construction Loan
The process of acquiring the construction loan and closing is significantly longer and more complex than a conventional loan. Not only do you as the borrower have to be approved, your builder also has to be approved, and your project has to be approved.
Your lender will look at your credit report, income, assets, liabilities, etc. for your approval. Then they will look at your builder’s credit report, their project history, subcontractor references, supplier references, and check to make sure they are licensed, bonded, and insured.
And then they will want to see all of the project details, from the contract (which they will probably want to be fixed cost, not cost plus), the cost breakdown, plans, permits (you’ll need to have these in hand before they will give final approval), and the appraisal of the land and the project.
Finally, they will most likely require you to have utilities (water/well, sewer/septic, electric, and gas) already at the property before you receive the construction loan. They’ll also require the architectural plans, final permits, and your builder contract. That means you’ll end up paying for this out of pocket.
There may be an opportunity to be reimbursed for that out of your construction loan, but you’ll need to talk to your lender about that before you make any of these purchases if you need to be reimbursed. This doesn’t go towards your down payment. Make sure to factor all of these costs in when planning your budget.
Construction-Only vs. Construction-to-Permanent
There are two different types of construction loans: construction-only and construction-to-permanent. A construction-only loan will only cover construction costs, and then you as the borrower have to get a mortgage loan to pay off the construction costs.
A construction-to-permanent loan will automatically roll over into a mortgage after you get the certificate of occupancy on your newly built home. Talk to your lender about which option is right for you and your project.
What to Expect/Some Tips
If you are currently renting and don’t have a mortgage payment, your lender will most likely not factor your rent payments into your approval process. If you own a home and have a mortgage, that will count as a liability with your lender.
It may be better to purchase the land and hold onto it for a year or two before going through the approval process for your construction loan, especially if the land will appreciate in value. But if you are financing the land purchase, your lender may have a very specific timeline for how long you are allowed to hold onto the land without moving forward with development. It would not be surprising if your lender required you to move into a construction loan within three years of purchasing the land.
Make sure you are working with an experienced builder. This is a benefit to you for several reasons. Number one, they’ll be able to help walk you through some of this process because they’ve done it before and know what to expect. Number two, they’ll get approved by your lender much easier if they have experience doing a project of your scope and value. Lenders want to mitigate risk wherever possible to ensure their loans get paid back.
Talk to more than one lender. Ask lots of questions. Make sure the lender you choose to work with is someone you are comfortable with, and that you fully understand their construction loan process and requirements. Every lender is going to have some variation.
Get your builder involved early. It’s incredibly helpful to your builder and your project if you get them involved as early as possible, even before you’ve purchased the land or picked out your architect or home plans. And if your builder works from a design-build process, even better!
Last but not least, don’t forget that it will take time to get approved. This is not your standard 30-days-to-close loan. The process can be difficult and arduous, and there are almost always hiccups along the way. It can be a strain on your relationship. So take a deep breath and make sure that a custom new home build is something you really want to do before you take the leap into the construction process.
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