Construction Loans for Consumers

This article was written as an aid for calculating down payments on construction loans - keep in mind these are not hard-and-fast industry rules; the protocols and guidelines are from the author's purview as a lender. Enjoy!

Calculating Down Payments and Draw Schedules

When an individual would like to have a home constructed on a building lot not located in a developer’s subdivision, they will typically need to contact a local lender regarding construction loan financing. These loans are more complex than traditional mortgage loans. There are multiple of steps the lender takes in order to protect the borrower, as well as their security interest in the property. Calculating down payment has additional variables that typical purchase mortgages do not. These loans are not funded 100% at closing either, the loan balance grows as the building project progresses. Here we will learn how to calculate down payments under different scenarios and discuss a basic schedule of draws.

First, some of the basics as to how these loans work…Before any construction can begin, a settlement/closing has to take place. This is done with a real estate attorney or title company. When the applicant applies for the loan, the lender will require all of the plans, specifications and list of materials, cost breakdowns, builder licenses, and several other forms and documents. This information will be used to order an appraisal, before the home is constructed, so that the owner and lender know ahead of time how much the market value of the property will be. Appraisers are able to establish a hypothetical valuation: when the home is built to specification, this is what the value should be. The correct protocol is to have a sales comparison approach used to determine the value; this means that it matters not how much it costs to construct the home, it matters what price it would bring on the open market. The appraiser will look at how much similar homes (comps) have sold for recently.

This brings us to establishing what is called the “acquisition cost” of the project which is defined below. Naturally, the "market value" and acquisition cost are often not the same.

The cost of the building lot being purchased plus the cost of the new home (all costs associated with the design and construction are to be included, even the architect)

Alternatively, if the building lot is owned by the borrower: the site value of the lot plus the cost of the new home determines the acquisition cost

Oftentimes, this figure does not match up with the market value determined by the appraiser and the borrower will have to decide whether or not they are comfortable paying more for the property than what they could sell the completed home for.

Lenders may restrict their maximum loan amount based on the lesser of the two above figures. If a bank will lend 89% loan-to-value (LTV) that means on a $100,000 valuation, they would be willing to lend $89,000. Let’s use some more detailed examples to determine loan amounts under both the cost/value scenario:

• An individual finds a piece of land they agree to purchase for $50,000 and their builder has agreed to construct their new home for $250,000 turn-key, therefore the total cost of the new home = $300,000 – this is our acquisition cost which multiplied by 89% max LTV = maximum loan of $267,000 and the borrower would put down $33,000 as a down payment unless…
• Let’s use the above figures but assume the home’s market value is only $290,000 as determined by the appraiser; then we take 89% of that figure for a maximum loan amount of $258,100 and the borrower, who still needs $300k to buy the lot and build the home, would need to make a down payment of $41,900 (this figure does not include closing costs

What if the borrower already owns the plot of land? The above situation may become more complicated, especially if the lot has a mortgage (land loan). More often than not, the lot is already owned and typically it is owned free and clear so let’s start with that scenario:

• $50,000 value of the site (as indicated on the appraisal) + $250,000 turn-key cost of new home = $300,000 times 89% = maximum loan amount of $267,000 instead of having a down payment of $33,000 like in the above scenario, the equity in the site ($50,000 of equity since the lot is unencumbered) will serve in lieu of a down payment. In this case only closing costs will have to be paid by the borrower. Most lenders allow this scenario.
• Now let us say that person still owes $20,000 on the land they used to buy the lot several years ago. We will use the same figures so we know the lender’s maximum loan will still be $267,000; however, since the borrower only has $30k in site equity, they would need to make a down payment. To calculate the down payment, we take the cost of the home, $250k, add their $20k loan pay off and that means they need $270k so the down payment would be $3000. They are only having to borrow $267,000 and the new construction loan will immediately pay off the existing land loan
• The formula for the above is: Acquisition cost (or appraised value, whichever is less) minus loan amount minus site equity = down payment and we already determined above how the maximum loan amount will be calculated so it should be easy to plug in any scenario to calculate how much down payment a borrower will need. Remember site equity = site (land + site improvements like roads/well/septic) value minus any land loan but let’s do another quick example with different figures: $100,000 site value that currently has a land loan mortgage of $55,000 and the cost of the new turn-key home is going to be $350,000. That means our acquisition cost is $450,000. Let’s assume everything also appraises for $450k. We know that the maximum loan amount is going to be 89% of $450,000 which = $400,500. So using the above formula we have $450,000 minus $400,500 minus site equity ($100,000 - $55,000 = $45,000) = $4500 down payment required: plus any closing costs/pre-paid items. This last example shows that the person has $45,000 in equity already, that is why they do not have to make a very large down payment

Regarding Draw Schedules and loan terms:

The construction period is generally 9-12 months during which the borrower makes interest-only payments. Once the home is 100% complete, the loan gets modified into a permanent mortgage and both principal and interest payments are made. Some lenders require a second closing but a combo construction/perm loan does not require a second closing, just a modification. Construction may not commence until after the initial closing, there is no “second closing” with a construction/perm combo loan.

Draws are made at different stages of the construction project. If a construction loan is like a big giant line of credit/credit card, then the draws are like making purchases. Typically, the draws are broken up into 5 phases which we will outline below but the percentages and hurdle points may vary:

• 20% after the foundation is complete (at this point a home-location survey is typically required)
• 20% Roof with felt on and interior framed
• 20% rough-ins (electrical, plumbing & HVAC) Installed
• 20% Drywall Installed with Exterior Vinyl/Brick Installed
• 20% Upon completion of the home

Most contractors are able to get to a completed foundation without having to outlay too much of their own funds. Banks typically do not pay for work that has not been completed, the exception being kit homes or modular homes that require upfront deposits, when that is the case, banks will pay the dealer directly after the loan closing.

A turn-key contract means that everything for the home is included in the price with the builder, the permits, the labor and the materials. Allowances can be made for items like cabinets/countertops but it is best to get an itemized cost breakdown for everything. This protects the builder and the home owner because if the owner makes changes, this could cause the project to go over budget. When a project goes under budget, the final disbursement of funds would not be for 20% but for the exact amount currently owed to the builder. Overages can and do occur, perhaps there was not enough money estimated for fill-dirt or the well had to be dug further than anticipated. When this happens, the home owner has to cover those costs out of pocket. Once a loan has been setup, you cannot simply request an increase like you do with a credit card: you have to start over from scratch so it is best to have an extremely thorough sales contract.