The HSH Construction Loan Primer

Introduction

There are very big consequences to selecting the wrong type of construction financing. At minimum, the wrong financing package can cost you several thousand dollars in extra closing costs. Closing costs have to be paid in cash.

Regardless of the type of financing, lenders will insist that you must first be able to qualify for the permanent loan.

Depending on where your new home will be, lenders may offer construction-only financing, "permanent" (regular first mortgage) financing, or various combinations of both.

If you're building a home which you intend to occupy, most lenders will offer you combination "construction permanent" financing. Customs vary from place to place, but there are two basic versions:

The first is a short-term construction-only loan which automatically "rolls" into the permanent mortgage when construction is complete. It's important that these two separate loans be treated as a package. If not, you will have to pay additional closing costs, and possibly, requalify for the permanent loan.

The second type is a single long-term permanent mortgage in which the money is paid out as the construction proceeds. Single loan financing is generally the lowest cost, most desirable financing, but you may or may not be able to arrange it. Policies vary, so check additional lenders if the first one doesn't offer this type of financing.

Construction loans, whether construction-only or part of a construction- permanant package, are usually interest-only. That is, you make no payments to principal until construction is complete. The interest rate is typically about 1% to 3% above the lender's Prime Rate at the time the loan is made.

Special Risks In Construction Financing

Your financing 'package' will most likely be comprised of separate construction and permanent loans. This type of financing poses several risks, primarily due to events which can occur during the period between the time you are initially qualified for financing, and when you must be requalified before the permanent loan can be closed.

Anything which affects your ability to requalify could result in losing your new home, and most -- or all -- of your down payment or the the money you've invested in a lot.

You may be able to avoid this type of problem by negotiating a fixed-price contract with the builder, but be alert for 'escape' clauses which are often included in this type of contract. Also, you may be able to realize a lower overall cost with a cost-plus contract if no unforeseen problems arise, so consider your risks carefully.

Talk to the lenders that you're considering. Try to determine how each would react if a problem arises. It's unlikely that you'll get any definitive answers -- lenders generally prefer a case-by-case approach -- but you may be able to get an indication of how much latitude you may receive. A lender might be willing, for example, to extend the construction loan for an extra month or two to allow time for you to raise the extra money.

Finally, if at all possible -- even if you have to cut back on your plans a bit -- maintain an extra "cushion" of about 5% - 10% of the total amount you expect to spend. The best way to do this is to postpone something, perhaps a garage, fancy flooring, or other part of your project that can be easily added later. It's just good insurance.

Before You Apply

Are you ready to do some serious mortgage shopping yet? Almost. If you haven't yet found a good real estate attorney, now is the time. A mortgage is complex, and competent legal help will steer you over the rough spots. The attorney's job is to accumulate and review the ream of documents you'll generate during the application, processing, and closing stages, and to be alert for problems that could delay or prevent the closing.

Just as important, the lender may in fact require that you have an attorney (or, in some areas, a title company or escrow company) to act as the trustee for the disbursement of funds from the lender. One of the better ways to find a competent attorney, if you don't already know one, is to ask for references from friends and coworkers who have recently closed on a loan. Real estate is a specialty business, so it's best to have an attorney experienced in this area.

Next, if you haven't done so yet, it is time to prequalify yourself. Prequalification is an informal check to see if you can financially afford the loan; you must be able to demonstrate that your income will cover the loan payments, the closing costs and other loan expenses, in addition to your other debts, and that your assets will cover the down payment. (In areas where land values are high, your building lot, if you already own it, may be sufficient to cover the down payment.) Most lenders require that you be pre-approved for your permanent mortgage before they consider a construction loan, and there may be additional requirements.

The actual chore of "shopping" for a mortgage isn't all that difficult. The preceding chapters should have taught you by now that mortgages are a product, just like a car or an appliance. You decide on the model you want, and its optional features (if any), and find a couple of competitors offering the product. Have your paperwork ready, and don't be blinded by an obsession with finding the "best" price.

You've prequalified yourself, so you are reasonably sure of how much you can borrow. You've checked out your own credit records, to avoid needless delays once the process starts. You've found a good real estate attorney to help you with the reams of requirements and paperwork. And you've made an appointment with a lender to submit an application.

As we've seen, the lender will first want to qualify you for the permanent loan, so we'll start there.