WOULD YOU HAVE DINNER WITH YOUR LOAN OFFICER?
Today we are going to talk about construction loans and loan officers. Well, mostly construction loans.
If you are thinking about purchasing a new home, renovating your existing or building something entirely unique for your family, one of the first questions you might have is where will we be getting the money to pay for all of this?
Would you sit down at a table and enjoy a meal with your loan officer. In this episode we discuss the dynamics of a lender and borrower relationship.
Unless you have been saving up to pay cash for your construction, one of the first things you do is look for that loan. You want to get pre approved. You want to know that you can do what you plan to do.
There are two very important differences surrounding this idea. There is the amount the bank believes you can borrow. and there is the amount that you know you can borrow or should borrow.
Just because a bank approves you for a certain value does not mean that you need or should accept that full value. You need to evaluate your financial goals and what is right for your family. How do you want to best utilize your current capital and your future capital.
When you borrow money you’re predetermining how you will be spending your future income. We all make choices.
My recommendation to you is figure out your budget that you can invest in your home and based on a budget that feels comfortable only take on a loan and mortgage that would be 80% of that. If you feel that you can invest 150,000 into your house only invest 120.
What this will do for you is it will keep you from over building. It will keep you from over extending yourself and creating financial difficulties for your family. The reason that I am mentioning all of this is because, if you do have good credit and you do have good financial history of being responsible your bank will give you more than you need. Bad economy or not.
The banks are starting to really pick up. They have gone through some major trouble and now they need to start lending. They need to make some money. Creating loans is a great way for a bank to make money.
The bank is making money off giving it to you. And it would be really difficult for people to afford their house if they did not have access to that resource. So it is very necessary part of most if not all construction projects.
So knowing all of that, how does it work, from a construction side. What is the process? I am going to cover everything hopefully not skipping over anything. I have some notes here. The first is:
You have the idea you want to construct. You typically call a contractor first. I don’t know why people do this, but most of the time they just have the immediate reaction of I need to find the person that will build it.
They are either going to try and sketch something up if it is small or they will recommend that you find a designer to draw up plans.
So far you have not paid anyone.
Now comes the designer/architect. You interview several people and get several proposals. This will be your first sticker shock. It always is. For one there is a fee to do the design and the fee is typically all or mostly due even before you have a loan to do the project. So you will have to come up with roughly 8%-12% of the overall construction budget that will be paid to the Architect. We can talk about the value of this fee and why it is what it is in another podcast but lets just accept that for now.
So you pay a retainer for your architect to start then along the way as well and you end up with a construction set of drawings that then goes to the building department and some other departments to be reviewed.
When they are submitted you have to pay a fee for them to be reviewed.
Then when they are ready you have to pay a fee to complete the permit. And depending on jurisdiction you are looking at any thing from $1,000-$20,000. So on a $400,000 house you have paid $32,000 in architectural fees and maybe $5,000 in permit fees. So you are looking at close to $40,000.
You start meeting with your loan officer. They are going to gather up your plans, specs, contractor budget, schedule of values, any insurance from the contractor showing they are going to spend the money wisely, building permit (some banks will require this before they close), and possibly an inspection schedule.
They have an appraiser research and provide a value based on what you are doing as well as current conditions. The value and price should align and the project can get funded and go forward.
So now you have this amount of money waiting for you to draw from it. The loan has a certain amount of interest attached to it. Typically the interest rate is 2 to 3 times that of a traditional mortgage. Because this is a construction loan. Once the construction is done it will be converted to a mortgage. Typically mortgage companies don’t give construction loans. Banks will give loans then sell it to a mortgage company later.
So you have access to this money lets say the 400,000 example from earlier.
The contractor has a budget or bid and he/she works that into the schedule of values like I mentioned earlier. I will have an example of that on the website under this episodes notes. This is episode 27 by the way.
The schedule of values will have dollar figures associated with particular stages of the project. Each time the contractor completes a stage they will submit an application for payment.
Your architect would review it agains the work that has actually been done and certify it. That would then also be signed by you and that with the lien wavers from the subcontractors would be given to the bank.
The bank would then send a check to the contractor. At that point you start paying interest on the amount you have drawn thus far. It is typically an interest only loan during construction. The bank will typically send someone out to check on the construction, but they are in no way checking for quality or inspecting for issues. They are just verifying that what was said to be done was done.
Once the construction is complete the loan will close you will pay closing cost and it will be rolled into the mortgage. It cannot be converted until the contractor signs off that they have been fully paid and all the subs file lien wavers saying that they have been paid by the contractor and there are no liens on the property.
Be prepared to put down 20% of the loan during closing. Typically banks are only financing 80%. That would be another additional 40,000. So for a 400,000 construction you could potentially be investing 80,000 out of pocket initially.
Before the recession banks were loaning out a lot more money and several people got caught in the chaos. A friend of mine working at his job, a job that he thought was pretty stable was all shaken up by this. He was building a vacation cabin in the mountains on a piece of property that he had owned for several years. He was finally going to build his dream vacation home. He and his wife had a design and started the construction loan.
Then his wife lost her job. Construction continued on. The bank decided that because their income was not what it had been before they were not going to roll the loan into a mortgage. The loan had a one year life on it. After that one year he could not find anyone to take is mortgage and he could not pay off the loan required by the bank so the bank foreclosed on his cabin and he lost his land and his dream.
Sounds pretty awful right. This is one reason that I mention the financing information at the beginning of this episode. Don’t borrow the full amount that the bank is happy to give you.
Make sure that you are in control of the finances and you plan accordingly for your family. After all it is your money. You are the one making the commitments to pay it back.
The last thing I wanted to say is
“I know that this sounds dreadful and probably kind of a downer. I really don’t want to make this sound impossible or that you can’t or should not pursue your dream of making your house what it should be for your family. My goal is to make sure you are prepared to push through the difficult stuff.
When you know the issues and you know the challenges we can find solutions to deal with them. In some coming episodes, I will be talking about some ways that you can make this all work. I hope to come up with some creative solutions for you that helps break down the barriers.
And one last final comments. When you are getting into a construction loan, make sure that you fully understand the terms of the agreement.”
I hope that you are having great success with the planning and construction of your home. If you want to get in touch with me please reach out to me on twitter or google plus.