How to Get a Construction Loan
An Interview with a Real-life Mortgage Specialist
As a custom home builder, I can’t even tell you how many clients have come to me with concerns about obtaining a construction loan. They hear or read online that construction loans are harder to get than regular mortgages, or that the process is very difficult.
But the truth is that it doesn’t have to be difficult or complicated, as long as you’re working with experienced professionals who know what they’re doing.
We’re fortunate enough to have Dino Paone from Santander Bank to help us de-mystify the process. Dino has been kind enough to answer some of the most common questions I get from potential home builders.
What’s the difference between obtaining a regular mortgage and obtaining a construction loan?
Obtaining a construction loan is actually very similar to obtaining a regular mortgage. The main differences are:
- Construction loans require more paperwork, such as plans, cost sheets and builder contracts. A list of requirements will be provided to you by your lender.
- Construction loans require more upfront dialogue and lender expertise.
- Construction loans can be more difficult to qualify for in some cases when the client is currently paying a mortgage or rent while simultaneously carrying the construction loan and related costs.
How do construction loans work? Are there different types?
In general, construction loans work like a line of credit or a high-balance credit card. The borrower is approved for an amount of money for the project, and the credit line is tapped in stages or “draws.” The borrower can request a draw at various stages of completion.
A unique feature of a construction loan is that draws can only be given for “work in place”—meaning that the borrower does not get money in advance for items that need to be paid for upfront. The draw is granted for the work that is completed to that point—not for what will be completed later.
There are two types of construction loans—single close and two close. Like anything else, there are advantages and disadvantages to both. A selling point of the single close construction loan is that you spend a bit less money than you would on two closings. However, the two close construction loan offers program flexibilities and long term lock advantages that very often end up saving you more money and time than the one time close.
While one is not better than the other, one might be better for your specific needs. That’s why it’s important for a borrower to be matched with a construction lender that is highly experienced, creative and advice driven. Otherwise, you are buying whatever the lender has to offer instead of being advised of how to best maximize your experience and results.
Does the builder take care of this or do I need to do it? What’s the first step?
The builder is usually in a great position to recommend the best Construction Lender to you. The builder’s concern is keeping the job moving and being able to pay his subs on time. A great construction lender is able to keep your job moving, money flowing and relationships cordial between all parties.
Using the lender your builder recommends is a great idea since the builder has worked successfully with the lender before and knows that they are efficient, easy to work with and professional.
Will this process be harder if I’m a first-time buyer?
The process is the process, so I don’t think it is any more difficult for a first-time buyer or a seasoned purchaser if it’s the first time building for both of them.
If you work out at the gym every day and then decide to run a marathon, you think you’re in great physical condition until you run the marathon. Vice versa for the marathon runner who’s never lifted weights. You’re in shape but not in lifting shape.
What kind of credit scores are lenders looking for?
This is an interesting question and one to be very careful about. Construction loans and end loans (the loan you get when the construction is completed, like a 30-year fixed, for example) have different rules, regulations and are even governed by different departments.
When we do a construction loan for a client, we always approve the end loan before we do the construction loan. We want to be able to make sure that the customer is aware upfront of all fees, rates and programs that are or are not available to them, so that they can make conscious and smart long-term decisions about building with full knowledge and proper expectations for the final result.
What are the rates like? Do I have to put anything down or is it 100% financing?
Construction loan rates are not really worth much discussion. The borrower pays monthly interest only on whatever amount that they’ve borrowed. Rates change over time but have been in the 4% range for a few years now.
Construction loans always have a fee involved—usually 1 point (1% of the total loan amount borrowed). This is because construction loans are short term loans and lenders can’t make any real profit because of the duration of the loan. The point paid is the profit.
Still—construction loans are not profit centers for lenders. They are simply a service provided to keep homes being built and they lead the lender to an end loan which has normal collection methods and normal profits.
Normally, construction loans provide up to 75% of the cost to build the home. End loans at completion can go to 80% of the final value of the home. A construction borrower will always need a good amount of money on hand to be in the construction game.
Can I use this loan to buy the land as well or is that something different? Or do I need to own land before I qualify for a construction loan?
A borrower may finance their land purchase as part of a construction loan with us at 65% of the land value. The borrower is responsible for a 35% down payment. Many construction lenders require a larger down payment on the land portion and many will not finance land at all.
If the borrower does own the land prior to construction, we can give them up to 65% of the appraised value of the land as their first draw. If there’s already a loan on the property, it will need to be paid off with the construction loan so the construction loan is the first lien on the property.
So it may be possible to finance the entirety of a project if the borrower has land with no mortgage on it.
What are the repayment terms like? Do I roll it into a mortgage at that point? If so, would my mortgage lender have to be the same person or could I look elsewhere?
Repayment terms on a construction loan are the same as any loan. Payment is due monthly, interest-only for construction draws, on whatever balance is outstanding at the time of billing.
One time close construction loans roll automatically into an end loan at the completion of construction. Two close construction loans work the same way. The end loan is approved and ready when construction is complete.
We only do construction loans for end loan clients. There is too much time, work and expertise involved for us to not do it that way.
I have seen situations where a customer has done a construction loan in one place and an end loan in another. It never works out well. It’s like starting over for no good reason and there are too many economies of scale that are given up in the process.
Should I expect this to be a difficult process? Are there any advantages to getting a construction loan?
Our experience is that there are no difficult processes if you deal with professionals all around. If you have a great builder and a poor lender, you signed up for a nightmare. Likewise, a great lender is not building your home, so you could have a great mortgage experience and end up with a bad house or builder experience.
Most of our clients allow us to be the point guard on their team. If I recommend a builder and a title company to my client, it’s because I want them to have the best experience possible by being surrounded by professionals on all sides that work together to deliver a great experience.
I always tell my clients if they go with my recommendation and something goes wrong, call me and I’ll fix it. It’s my responsibility. On the other hand, if you choose the individual parts, then you’ve become the point guard and you take on the responsibility for each part. That doesn’t seem to work out as well as leaving it to pros that you trust.
My current home isn’t paid off. Is that a problem? Can I keep my current home or do I need to sell it before I can get a construction loan? Should I have my current home appraised?
As long as you qualify for the construction loan and the end loan while carrying your current home, then you can keep it. If not, we’ll figure out a solution on how to get your new home built as long as everyone is flexible.
It’s best to go into a construction project with the mindset that you are signing up to be a bit uncomfortable for a while. It’s like having kids. There is some discomfort at times along the way, but the payoff comes big on delivery day.
What if something unforeseen happens and my line of credit doesn’t cover all of the construction costs?
We work diligently upfront to avoid that possibility. This is one of the prime reasons that you need an experienced professional to map out a strategy and a team that is responsive to each other and creative in their execution.
Is getting a construction loan the only way to get this done? Do I have any options?
If a borrower has a primary residence with a ton of equity, they could look into cash out refinancing on that home to finance the construction of their new home. This option sounds good initially until I advise clients that they are paying full amortization on this type of loan, which means they’re paying for the money before they even use it.
Another option is always cash, if it’s available. However, with the inexpensive cost of money for construction at interest only, it’s almost always more cost effective to get a construction loan.
About Dino Paone
This year marks Dino’s 26th year of service to his clients. He spent several years in the real estate and financial services industry before starting his own successful mortgage banking company. Dino has held several designations, including: Licensed Mortgage Banker, Licensed Mortgage Broker, and Registered Investment Advisor.
Dino gives all of his clients his full, undivided attention. He has spent three decades honing a reputation of honesty and integrity. Contact him here to learn more.
“ I can’t say enough good things about what a great experience this has been…”