To Build or Not to Build: Part 2
Local experts provide insight on financing your home construction.
This month, we continue our homebuilding series with a focus on financing. Once a prospective homeowner decides to build, how do they obtain financing for construction? To answer the many questions that come up when deciding on financing, we talked with several lenders in the Columbia area who specialize in construction loans.
Jill Cox, senior vice president of commercial lending with Central Bank of Boone County, believes that a good relationship can help alleviate a lot of stress in the home-building process.
“I think it’s important for people new to the process to go in and talk with a lender and also interview builders,” says Jill. “It’s a good idea to get recommendations on builders who construct homes in the price point you’re looking in, and lenders can help with that. The relationships between the borrower and the lender and the borrower and the builder are key to a successful and smooth construction process.”
Eric Morrison, president of the Columbia market for Providence Bank, believes it’s also important to understand the costs associated with building by putting together a realistic budget. Once that budget is assembled, it’s time to meet with a lender about what’s feasible.
“Really put pen to paper on what it all means in terms of a payment — it’s good to look at it this way before putting a shovel to the ground,” Eric adds.
From a banking perspective, Eric says building a home requires a little bit of savings in your bank account and room for error because there will likely be unexpected expenses along the way.
“Sometimes people have thoughts of building a home, but they might not be ready to manage the build financially at this point,” says Eric. “A fair amount of risk management is involved when we build a primary residence.”
“If someone is contemplating building a house, or even buying a home, it’s important to go through the process of getting pre-qualified,” Jill says. “It’s better for potential buyers to know how much home they’re qualified for on the front end before they begin looking. This may help them avoid potential disappointment while also providing direction to them.”
How to Find a Lender
There are several determining factors when it comes to choosing a lender. Knowing the lender or being a current client with the bank can be good reasons for choosing them for your home, but other factors, like rates offered by the lending institution, influence the decision, too.
“People often pick lenders based on who others recommend, or if they already have experience with a particular bank,” Jill says. “At Central Bank of Boone County, we have a lot of experience making construction loans. We feel that our system is very efficient for both the borrower and the builder.”
“Whether it’s utilizing your chamber of commerce or personal and professional references to find a lender, that’s a big, proactive step in making sure it’s a successful project,” says Eric. He also advises prospective homeowners to seek advice from their banker early in the process.
Once a client has had the conversation with the lender and seems ready to move forward, they should complete the application process online for their construction loan just as they would a home purchase loan. Once completed, the application will be underwritten based on several metrics, such as account balances, credit history, etc. The lender and borrower then come to an understanding of the terms and how the construction process is going to work.
“Here at USA Mortgage, we have a dedicated team handling construction and renovation loans,” says Reza Abadi, regional manager at USA Mortgage in Columbia. “We will walk our clients through the entire process step-by-step to make sure they’re not overwhelmed while communicating with builders and contractors involved in the transaction. It’s one big assembly line, and it takes a team to accomplish the finished project smoothly.”
How Does a Construction Loan Work?
“Construction and renovation loans have a lot of moving parts, which require an efficient and clear roadmap,” Reza says. “We recommend that our clients be very detailed and decisive when it comes to planning their construction loans. It’s more difficult to do modifications as the project moves through the milestones. The goal is to over-communicate in the beginning to prevent any future issues and delays.”
Eric points out the main difference between a traditional home loan and a construction loan is that a construction loan requires a piece of land you have to build on, whereas a traditional home loan has an existing freestanding home that you’re purchasing.
When going through the process, it’s also important to start with and understand the history of ownership with the property. “For example, make sure there aren’t any easements on the property,” Eric says. “Before anyone would buy a piece of land, they ought to make sure they are doing a title and survey search to be sure there aren’t any unexpected consequences or title discrepancies.”
Jill adds: “In our bank, the commercial lending department provides new construction financing. With a construction loan, the money is drawn as the project progresses. The borrower doesn’t receive it all at once like with a traditional home loan.
“We qualify you for the construction loan using your debt to income ratio and credit history, just as we would for a permanent home loan,” Jill continues. “Once you’re qualified based on your income and credit, an appraisal is ordered using your home plans and cost estimate. This helps the bank (and the borrower) to know that the home will have an adequate market value to support the debt.”
Jill explains that, typically, draws are made on a construction loan on a monthly basis. The first draw may cover the cost of the land. After that, draws are made based on invoices presented. For example, the builder might present invoices for the permit, excavation, concrete, etc. Money is drawn from the construction loan as the project is built. These draws can be handled in person or online.
“With a construction loan, the borrower pays monthly interest on the money that has been drawn on the note to date, rather than on the entire loan commitment,” says Jill. “In addition, it’s easy for the borrower to transition into a permanent home loan.”
Moving from Construction Loan to Permanent Home Loan
Traditionally, the homebuyer would obtain a construction loan to build their home. Jill says construction loans are made separately from the permanent loan; construction loans are considered short-term and are generally provided on a nine or 12 month note. Once the home is built, the borrower refinances into a long-term, fixed-rate mortgage.
At Central Bank of Boone County, this is an easy conversion, as the borrower is approved for both the construction and permanent loan at the beginning of the construction process. “When the home is about 45 days from completion, the borrower works with the mortgage lender to get ready to move from the construction loan to permanent long-term financing and lock in the rate,” says Jill.
Borrowers can also close just one time, an option that’s offered at USA Mortgage and other lending institutions. At the end of 12 months or when the build is complete, the construction loan automatically becomes a permanent mortgage. This traditional mortgage can come in several different varieties, such as a VA loan, FHA loan, USDA loan, or a conventional loan.
“The important thing is to talk to your lender about your unique situation and what options are available,” says Eric. “There are lots of bankers are out there with expertise, but they can’t help you if they don’t know what your needs are.”
Final Tips on Financing
“The best tip I can give is to make sure to work with people you’re comfortable with and can trust,” says Jill. “It makes for a much smoother and more enjoyable process.”
Eric adds, “As a banker, I think the important tip or trend is that the more savings you can do prior to building or in preparation, the better off you’ll be. If you think that someday you want to build, start saving now.”
During the process, Eric says, “don’t be afraid to ask questions. It’s your project — you’re the one potentially purchasing the project, so ask all you want to ask. Building a house is a big deal. If you’re not comfortable and you don’t ask questions, you’re the one who ends up with the end product.”
Eric also cautions against deals that seem too good to be true. “There are very few deals that are really too good to be true,” he says. “When people are building homes, do your due diligence.”
“Building a home should be a fun process,” says Jill. “People tell a lot of horror stories about building a house, but it shouldn’t be that way. It should be enjoyable. It’s pretty exciting to build a house!”