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Nuts and Bolts of Construction Financing
by Gene Foley
The construction of a new home should be a fun and exciting experience. Knowing the basics to home buying will help to eliminate some stress during this process. Good planning for new construction just may be the difference between a good night's sleep and insomnia.
The first step is the selection of a general contractor. Most contractors have property available to view for references. If this is not an option, ask the contractor for some names and phone numbers of previous clients. Most people are more than happy to talk about the workmanship in their new home. Much like a new car, people are proud of their new purchase and will give insight on the contractor.
Once the general contractor has been selected, the next step is to negotiate the contract. Make sure all questions are answered before signing the agreement. Know what exactly is included in the contract. If there is a question about what is in the contract, make sure it is in writing.
Offering to do some work in exchange for a credit (i.e. painting) may be more aggravation than the credit is worth. The time it takes a contractor to do the work, as opposed to the buyer, may be more cost efficient.
After the contract is negotiated, it is time to focus on the financing of the project. Some general contractors will finance the project themselves, so the buyer need only secure the end mortgage. When selecting this type of mortgage, a concern could be the term of the rate lock. If the home is going to take four months to complete, then a normal 45-60 day rate lock will not be enough. The borrower should investigate the rate lock options that extend past the expected completion date. This allows for any delays that the builder may experience, such as bad weather.
Another common financing scenario is when the buyer supplies the construction money. There are a few things borrowers should know in order to meet their needs. First, a low, permanent end loan rate is more important than a low, construction loan rate. The construction rate is only in effect for six to twelve months while the permanent financing may be in effect for up to 30 years. Second, construction permanent loans have only one closing. The documentation signed at the closing may be modified for the permanent financing to take effect, or, in some cases, the loan starts amortizing at an agreed upon rate when the house is complete.
During construction, most banks charge interest only on the funds advanced. Therefore, monthly payments increase as the total money advanced increases. Once construction is complete, payments include principal and interest.
Funds are released during construction according to a schedule of disbursements agreed upon prior to closing. Lenders usually release funds within a week of a request, sometimes sooner. Funds are typically advanced for work completed, not for unfinished work or supplies on site. Once an inspection has been made, with a fee of $50-$75 per visit, funds are generally wired into the borrower's checking account, and, in turn, the borrower writes the checks to the builder. This gives the borrower final control over the disbursements.
Example
Loan Cost $ 35,000
Construction Cost $115,000
Total Acquisition Cost $150,000
Total Acquisition Cost $150,000
Down Payment $ 30,000
Loan Amount $120,000
The borrower will be putting a total of 20% down, which is $30,000. At the closing, the borrower put $7,000 down for the purchase of the land, so the lender released $28,000 for the balance of the land.
The total loan amount is $120,000. The lender has already released $28,000 for the land, so the remaining calculations will be figured on the remaining balance of $92,000.
Payment #1
The first payment is made to the general contractor in the amount of $14,000 for plans, permits, excavation, foundation and back fill.
Bank Allowances
Plans and Permits 3% $ 2,760.00
Foundation 9% $ 8,280.00
Total Disbursed 12% $ 11,040.00
Therefore, Payment #1 to the general contractor would consist of $11,040 in loan proceeds, and the balance of $2,960 would be from the borrower funds. This is also how the remaining $23,000 in down payment would be calculated. Additional funds are disbursed according to a specified schedule of construction, and can be in as few as one or over five separate payments, or draws as they are referred to in construction financing.
The first mortgage payment to the lender would consist of interest only on $39,040. This is the total of the land disbursement and the first disbursement. $28,000 + $11,040=$39,040.
Building your dream house has never been easier. Lenders with construction lending experience are a great resource. Sitting down with a lender to review the disbursement schedule and borrower obligations ahead of time will eliminate problems before they occur.
Gene Foley is a mortgage originator for the Rockland Trust Company and specializes in construction permanent loan programs. Telephone: (800) 826-6102 extension 6684.