February 13, 2007
Question from DT. I'm considering buying some land and I was wondering how construction loans work?
Well D.T., let's cover construction loans which can be taken out by the builder or by yourself. First the builder. The builder would get a construction loan for 6 months, usually from a bank and set up a fund control with the bank or another supplier that is authorized to run the fund control for the bank. He or she gives an itemized account of the funds needed and per line item how they are spent. The funds are released per completion of a group of items or by percent of construction completed.
The bank figures their loan on loan to value ratios, ie. the completed product and land, improvements, etc. An appraiser does this and then the bank loans 70% to 80% of this value. Say the lot and building, driveway, septic, etc. came to $250,000. The bank would loan 80% or $200,000 to fund the acquisition of the land and construction costs. So if the land costs $100,000 you would have $100,000 to build with. If your cost to build is $150,000 you would need $50,000 cash to fund your project.
Sometimes you can buy the land with owner carrying and subordinating to the construction loan. Given our $100,000 land cost, the owner might carry with $15,000 down. He subordinates his first position to the bank and gets his final payment in 6 months at construction completion when you get a permanent loan to take out the 6 month financing. Currently construction loans are about 1-1/2 to 2 points over prime which is 8-1/4 % as of this writing. They will charge points on the loan and title costs, etc.
Make sure your builder's costs include all the costs of construction, loan costs, hook up fees, etc. You don't want to get to signing on the dotted line and find yourself responsible for $2,000 in loan costs that were not figured into your cost analysis. You yourself can take out the construction loan and monitor the loan disbursements along with your builder. You will refinance into permanent financing when the construction period is over and usually the bank will rollover most of your original costs into your new loan.
Always check your builder, see homes completed, talk to previous clients, talk to his suppliers, check with the state that their license is in good standing with no complaints filed. And finally make sure your builder has insurance and even a completion bond if necessary. Building can be rewarding if you do your due diligence and check every issue out and assure yourself prior to signing any commitments.