Josh Alexander is a vacant land and construction specialist
at U.S. Bank Home Mortgage. He has been with the company
since 2011. Reach Alexander at (858) 649-9646 or
Financing New Construction
Residential homebuilding provides opportunities for borrowers and originators
By Josh Alexander
Custom residential homebuilding has be- come an increasingly popular alternative to the existing, competitive home market. Understanding the process can help originators guide borrowers through the process and close
more loans. Direct funding from wholesale lenders
is the preferred funding method, but for those times
when a borrower’s loan falls outside direct-lending
guidelines, it may make sense to partner with a construction specialist.
Construction loans are often one-time close products,
which provide funds for construction and then convert
to a long-term end loan. Borrowers will need to understand the terms of the final loan. Is it an adjustable rate
mortgage (ARM)? If so, what are the ARM terms? Are
credit and income underwritten again prior to conversion? Is there a prepayment penalty?
Fees on construction loans can be much higher
than for purchase or refinance loans. Title insurance
and endorsements are the biggest fees, but third-party fund control also is sizeable. After closing, the
construction funds are put into an escrow account.
Construction progress is monitored, and funds are disbursed from the account after expenses are justified
to reimburse the builder. On some construction loans
the client may accept a higher interest rate to reduce
Most homes constructed today are stick, or site-built,
using lumber-frame construction, as opposed to modular and manufactured housing. In fact, many construction lenders will only lend on stick/site-built projects.
For ground-up new construction, the loan to cost
(LTC) ratio is typically used for determining the financing. To determine the cost, processors will need the
builder’s estimate for constructing the home, which
should include the cost of the land, plus soft costs and
Soft costs include permit fees; engineering, surveying and architecture costs; and builder deposits. Hard
costs include just about everything else required
during construction, including labor and materials.
Typical LTC ratios on new construction run between
80 percent and 90 percent.
Rehab-remodel construction loans often use the
ture remains, may not qualify. The borrower’s equity
requirement is determined by the size and scope of
the project. The larger the project, the more of an
equity cushion is required.
For purchase-remodels, the best approach is a quick,
short-term purchase ARM to keep costs down and a
construction/remodel loan to pay that off. Although it
is possible to do a construction loan as a purchase, the
logistics make it unworkable. Sellers want to cash out
of their house fast and dislike extended construction
escrows. The critical construction-loan documents —
design, cost breakdown and contract — usually take
90 days or more to complete.
Some borrowers may want to finance the land
needed for a project, but vacant land financing is particularly rare. Although sellers of vacant land often get
asked to carry the financing, they would prefer not to
do so. Land loans usually take 45 to 60 days to close.
Some land lenders require a percolation test or septic
approval if the site does not have access to city water
and sewers. Either way, the land loan and/or seller
financing would be paid off by the construction loan.
A construction-loan application is similar to a refinance
or purchase application. Borrowers must supply income, asset and credit documentation. The difference
is that construction cost estimates from the builder
must be added to the file.
It is not always necessary to have approved building permits or a full set of plans at the time of application, however. A construction loan usually takes 60 to
90 days, and much of that time is spent designing the
floor plan and obtaining accurate cost estimates.
Most lenders have a builder-approval process. Owner-builders — where the owner also is the contractor —
are rarely allowed. A licensed and bonded general
contractor offers professional support and helps the
owner through the entire process. A general contractor
is the glue that keeps the whole process together by
coordinating with all parties involved — originator,
Realtor, architect, county-approval departments, and
A construction contract is usually signed by the
builder and borrower prior to work beginning. This
can either be a fixed-cost or cost-plus contract. Not all
lenders will accept both types of contracts, however.
Fixed cost contracts require more precise cost estimates
upfront and tend to prevent overruns, while cost-plus
arrangements are more open-ended.
At the heart of any construction contract is the
construction-cost breakdown. This is a list of all the
soft and hard costs involved with the home-building
project. Soft costs — often called owner items — are
paid outside the construction contract, usually prior to
closing on the construction loan. These usually are not
financed, although they should still be listed in the
application for determining the LTC ratio.
The size, scope and location of the construction project will determine the amount of time needed for
the build phase, which affects the loan duration.
Twelve months is standard for most builds, but this
timeframe can be extended for larger projects.
Monthly payments during the construction loan can
be optional or a requirement, and can be interest-only or principal and interest. These monthly payments will grow as disbursements, or draws, are
paid out. The contractor will request draws from the
construction-loan funds whenever a phase of the
build gets completed. An inspector will visit the site
and confirm the work completed before the funds are
Once the home is completed, a certificate of occupancy is issued by the local municipality. This is usually
mortgage options. n