Though the current economic climate presents some challenges, the time to build is now. Many builders and sub-contractors are seeking construction work and are willing to negotiate on pricing and terms in order to win your job. Prices for construction materials can also be a bargain in comparison to the boom years. The current challenges in building a new home are the real estate market and construction financing.
It's not news that the banking industry, real estate market, and economy have taken a downward turn over the last three years. National construction lenders like IndyMac Bank, National City Bank, Chase, and others have taken huge losses on new home construction loans. Regional and local banks offering construction financing have also experienced financial losses. Many lenders have closed their construction lending operations completely, and those who are still lending have severely modified their qualification policies and procedures. With fewer lenders, fewer dollars available, and more stringent lending practices, securing financing for building a new home can be tough—but it's not impossible. We'll walk you through the basics to help you navigate the process.
To understand how to qualify for a construction loan in today's market, you should understand that construction loans are very different from typical home loans. With a traditional home loan, you make a down payment, take possession of the home, and then make a payment to the lender each month. With a construction loan, you are asking the bank to estimate the value of something that does not yet exist—and then lend you money for it. A lot can happen during the typical 12-month construction process—from the expected construction delays and cost overruns to the unexpected—like a change in your employment situation or your builder going out of business. The risk to the bank is much greater, so it exercises greater caution in loan decisions.
A construction loan is really a reimbursement process. The bank does not advance construction funds; it will only pay for construction items that are complete. Each month you must submit a draw request along with supporting documentation to prove that building is progressing. The bank reviews the documentation, a third-party inspector visits the building site, and only then will the bank issue a reimbursement payment for the construction phases that are complete.
There are three major elements to qualify for a construction loan. Think of these three elements as the sides of a triangle. All three sides must connect for a construction loan approval. One side is the construction budget, including all the costs associated with building a new home. Side two is the appraisal value, or the estimated value of the new home when completed. The third side is the foundation of the triangle, representing the construction loan amount, including land equity and your down payment. Your personal financial qualifications determine this amount.
The Cost to Complete is your construction budget, and comprises the following elements:
The plans and specifications will need to be reviewed by an independent appraiser. They will calculate the value of your building lot and completed home and compare it to recently sold and comparable homes in the area. The construction lender must verify that the completed home value will conform to the local market. With an excess of homes for sale, foreclosures, and the general economy, home values have declined in recent years. Anticipating further declines in the market over the months it takes to build your home, your lender could hedge down the appraisal value.
Lenders want you to have more equity in the new home project, greater down payments, or land equity. Gone are the days of sub-prime loans and stated income mortgages. Construction lenders today want to see full documentation and asset-based qualifications. Your employment, credit scores, debt-to-income ratio, and other qualifications will be reviewed. With a maximum debt-to-income ratio of 38 percent, including both the payment on your current home and future loan payments, many homeowners will have to sell their current home in order to qualify for a construction loan.
Your dream of building a new home is not out of reach, but in today's market you must plan, prepare, and make a strong presentation to the construction lender. The market values and construction cost details that you present to the lender will have to meet underwriting guidelines. Be sure they are accurate, and verify all of your qualifications in advance. Make good use of the resources available. Some of the best resources in today's market are local and regional banks. Local banks understand your housing market; develop a relationship with them, and they can help guide you. Valuable online resources are also available. Check out www.startbuild.com, a comprehensive resource which can provide assistance with local construction loan options as well as project planning, construction budgeting, and project management.
Rob Mackle is the CEO of StartBuild, ePlans' exclusive resource for the industry's most accurate cost to build data. Check out our Cost To Build Estimator.