Home construction loans are somewhat more complicated and involved as compared to purchase money or refinance mortgage. The appraised value of a home combined with the borrower’s credit and income is what determines the loan amount and since in the case of a new home construction loan there is no structure to appraise the entire process has to be modified to accommodate that fact.
Future Value Appraisal
In the absence of a home, lenders rely on what is called a Future Value Appraisal where the appraiser uses the architectural plans combined with the line item cost breakdown to determine the overall look, size, room count and quality of construction, assumes the structure to be built to be an existing one and then studies existing current similar home sales in the area to establish a comparable value.
The Draw Process
A construction loan is a staged loan in that at the time of closing construction lenders finance the purchase or refinance of the existing lot or house that is going to be demolished, out of pocket soft costs of construction but do not fund the actual hard cost of construction.
No funds are advanced to begin the construction, unless there is a prior arrangement to pay deposits in the case of penalized or modular construction.
The contractor or the owner is responsible to float the expenses until the construction reaches a pre-determined milestone or stage at which time the lender orders an inspection, a title update and checks local authority inspection reports.
Once satisfied that everything with that stage of the construction is in order the lender releases funds, called a Draw. Typically there are up to 7 or 8 stages of construction based on a 12 month project.
What does a construction loan cover?
Strictly speaking there are two types of construction loans; stand-alone and construction to permanent loan.
A stand-alone construction loan will only pay for the existing liens and the cost of construction and will typically require payments during construction where as a construction to permanent loan will not only pay of everything involved in the process but will also have reserves to cover payments during construction and the final take out loan lined up.
Construction to Permanent Loans
These loans were developed some two decades ago. At first lenders were slow to adapt but now pretty much every lender involved in construction loans offers it.
The entire cost consisting of; pay off of existing liens, soft costs, hard costs, closing costs, contingency reserve and interest reserve are wrapped in and a permanent take out loan is finalized facilitating the simplicity of a single closing, the security of the final loan in place, savings in closing costs and allowing for easier qualification.
Qualifying for a construction loan
Before the advent of construction to permanent loans building your dream home was very difficult to qualify for since you effectively had to qualify for two loans, your existing housing and the new construction.
In a construction to permanent loan, interest only payments are calculated on the loan amount actually drawn and applied to the interest reserve account that is set for that purpose reliving you those payments though you may make those payments should you choose to. Meanwhile the contingency reserve that is set up protects you against any unforeseen cost over runs further.
Over all applying and a qualifying for a construction loan is a much more involved process requiring all the documentation that the lender is going to need for establishing value, determining the cost of construction and setting up the draw process.