With the current resale market being short on inventory and super competitive, there are some buyers who are switching gears to consider building their next home. Depending on the builder and location, you may be required to get a “Construction Loan”, and not an “End Loan”. I will explain the difference below and then give an idea what a buyer goes through on a Construction Loan transaction.
An End Loan is a standard mortgage that takes place at the end of construction when the home is complete. In this scenario the buyer will take ownership of the land and the home at the same time, only once the home is finished. They will typically pay for the home when it is finished with a 30-year fixed rate mortgage. Other than deposits, all of their funds for down payment, escrow, closing costs, etc. would be due on the day they take ownership of the home. This scenario is a lot simpler for the buyer and seems to be desired but not always attainable.
A true Construction Loan is a bit more detailed as it involves a series of interest-only payments for the buyer and draws made by the bank to finance the home as it is being built. One reason this option is appealing to builders is because it prevents them from having to tie up their capital. With a rising cost of materials, this is becoming important to some builders.
Once the buyer and the builder agree to terms on a contract, the lender needs to get all the drawings and all of the signed estimates. This information is given to the appraiser who will complete a report based on what is going to be built. The report will be made “subject to completion” of the home, but the value will be given by the appraiser. By this point the loan application will have already been signed by the buyer where the terms of the interest-only payment would have been disclosed, as well as the out-of-pocket expense.
The loan will then move through processing and underwriting as it normally would for any mortgage loan. The closing process is a little more involved as the closer works with the builder to iron out a draw schedule. The draw schedule needs to be agreed on by all parties. Typically there are several draws made throughout the construction period. The appraiser will have a role in the draw schedules as he or she will go perform re-inspections to confirm that the work has been completed as it was outlined in the draws. This inspection is a requirement before any other funds are released for the next draw.
At the initial closing the buyer will pay their closing costs and also put their desired down payment into the transaction. As more draws get released, their interest-only payment will increase as the interest is only being paid on the principal amount that has been put toward the work. As the work nears completion, the modification process is set up. Different lenders may have different options, but the buyer should be able to lock in their final interest rate well in advance of modification. The loan will modify into a 30-year fixed rate mortgage (or whatever term is agreed upon) once all of the work is finished. At the time of modification, the borrower typically needs to provide updated pay stubs and bank statements to confirm that nothing has changed with the income or assets. Also, at modification, there will typically be a deposit for the new escrow account that is due, so there are some fees that will need to be paid at the very end.
Construction Loan Flow Chart
Initial Application → Plans, Estimates, Drawings → Appraisal, subject to completion → Underwriting Approval → Closing, release of first draw check → Re-Inspections, interest-only payments, release of funds for remaining draws during construction → Modification into standard mortgage product once home is completed
David Fuchs, Traditions Mortgage
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