Home Construction Financing
The Basics and Beyond
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The Basics
Many of you reading this already own a home or have owned one in the past. Consequently, you may be familiar with this information. Even if you are, I would suggest that you read it again
as a review, because the requirements for home construction financing are constantly changing. For those of you that are first time home owners, you should consider this information as a good
start, but not a comprehensive review.
A down payment of at least 5-10% of the total value of your building project will be required. If your building project (land and house) is projected to be $300,000 you will need a minimum
down payment of $15,000 to $30,000.
Owner Builder Loans can be an exception to the above down payment requirements. Owner builder loans often require nothing down because banks assume the home owners will have a minimum of 10%
equity in the project by virtue of the owner builder participation.
The total monthly loan amount extended to you will be in the range of 50% of your gross monthly income. This amount varies. There are some financial institutions that may go as high as 65%
and there are other that will use numbers lower than fifty percent. Fifty 50% represents a debt to income ratio. This means that the bank will allocate 50% of your monthly gross income to pay
your housing costs, including principal, interest, common fees, PMI, taxes, and homeowner’s insurance.
For example, if you earn $5000 per month gross, the maximum amount allocated to pay your monthly housing costs would be $2500 per month. If one assumes a 6% interest rate and a 30-year mortgage
that translates into a total loan amount of $333,000 assuming $2000 per month in payment of principal and interest and $500 per month for taxes, insurance, common fees, etc. However, any monthly
revolving debt must first be subtracted from your gross monthly income before apply the 50% ratio. Extending the above example, if you had a car payment of $350/month, student loans of $125/month
and credit card bills of $75/month, the calculation to determine how much you can borrow goes like this: ($5000 – ($350+$125+$75))= $4450 X 50% = $2225.
If you currently have a mortgage and plan on selling your that property by the time you close your new loan, this monthly payment is not included. However, if you were planning on keeping
this property and renting it, then the monthly payment amount on this property would be included in the debt in the above calculation.
An exception to this might be made if you have a history of being able to rent the property, and this income offsets the monthly payment you make. However, if you are currently living in the
property it will be difficult to show a history of rental income from it and your financial institution will probably include this debt in its calculation. Furthermore, if the bank does accept
rental income as an offset, they will only allow 70-75% of the monthly rental as an offset – not the full 100%.
The mortgage industry has changed a lot in the past decade. Historically most financial institutions used a 28/38% ratio to calculate the loan amount for which you qualified. The today’s more
liberal guidelines you can borrow much more money. This change has both positive and negative implications. The ability to borrow more and buy a bigger or better house is certainly a positive
one. However, the negative that consumers need to consider is the debt load under which they can put themselves. In other words, just because the bank will loan you up to 60% of you gross monthly
income, that doesn’t mean that you can afford to pay this amount.
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Construction to Permanent Loans
Most people who are building homes will be interested in something called a construction to permanent loan. This is a loan that is specifically tailored for the home building process. It is
really two separate loans fused into one.
The first part is the construction loan, used during the building of your house; it works like a credit line. Once you are approved for a specific amount, you write checks against that account
as you buy your lot and then as you begin to pay the builder. The payments you make are “interest only” payments during the construction phase based upon the outstanding balance.
The second part of the loan is the permanent loan, which is put into place once the construction of your new home has been completed. This is the common 30 or 15 year fixed, or an adjustable
rate mortgage.
Construction to permanent loans (CTP) will save you time and money because they require only a single closing. When selecting a mortgage product, make certain the lending institution you are
considering offers a true construction to permanent loan with a single close – and a single set of closing costs. There are financial institutions that will offer a construction loan followed
thereafter by a permanent loan-- but will put you through two closings and charge to sets of closing costs. Simply put, there is no need to go through this, or more importantly, pay for this,
so make sure you know what you are getting when you shop for you construction to permanent loan product.
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Credit Reports
Several years ago, credit scoring had only a modest impact on home mortgages. That has all changed. Lenders studied the relationship between credit scores and mortgage delinquencies and found
a definite relationship. Almost half of the borrowers with FICO scores below 550 became 90 days delinquent, at least once, during the term of their mortgage. Compare this to borrowers with FICO
scores of over 800 – here the delinquency rate was only 2 in 10,000.
FICO stands for Fair Issac and Company and is the credit scoring system used by the three major credit agencies in the U.S. These three companies are Trans-Union, TRW (Experian), and Equifax.
How does your FICO score impact your mortgage application? In two ways: One way is in the acceptance or rejection of your application. The other is in the rate/amount that you get charged.
For example, some lenders establish a base price and will reduce the points on a loan if the credit score is above a certain level. Other lenders, instead of reducing costs for good FICO scores,
will add costs for lower FICO scores. The net result is the same. A lower FICO score may result in more costs or charges to the borrower.
Because of the impact of FICO scores on your mortgage, it is important to understand those items that have a negative impact on it. Some of these are:
- Delinquencies
- Short Credit History
- Revolving Credit accounts (credit cards/charge accounts), maxed or near limits
- Bankruptcies, judgments, or liens
- Too many revolving accounts
- Too few revolving accounts
- Too many credit inquiries
Protect your FICO score. It is an important factor in getting the best rates and lowest charges. What is the best way to do this? Live within your means, don’t open needless or an excessive
number of charge accounts, and pay your bills on time.
Now that you have an understanding of the importance of credit scores, you can also understand why it is also a good idea, at the very beginning, to run a credit report on yourself. You may
not think you have bad credit – and you may not – but what about that person who is using your social security number fraudulently, or the bill you never paid to that thief of an auto mechanic?
It is well worth your time and money to take a look at your credit history and clear up any problems before you go talk to your friendly banker.
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PMI Insurance
Lastly, if at all possible, make sure that your down payment amount is at least 20% of the value of your total loan amount. If it is not, you will be required to pay something called private
mortgage insurance (PMI). The cost is based upon the size of the loan, but will cost the average homeowner several hundred dollars per year. Lenders require PMI on most conventional mortgages
because experience reveals a strong correlation between borrower equity and default. The less money a borrower has invested in a home, the greater the probability of default. Thus, PMI is a
financial guaranty that protects lenders against loss in the event that a borrower defaults.
If you are stuck with PMI for some period of time, it is important to know that your PMI must - with certain exceptions - be terminated automatically when you reach 22 percent equity in your
home based on the original property value, if your mortgage payments are current. Your PMI also can be canceled upon your request - with certain exceptions - when you reach 20 percent equity
in your home based on the original property value, if your mortgage payments are current.
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Beyond the Basics
Can I have someone co-sign a loan with me?
The answer is both yes and no. There is no such thing as a co-signer on a construction loan in the sense you are normally familiar with it. A co-signer on a construction loan is really a co-applicant
on the mortgage application. And, by virtue of being a co-applicant the person also MUST live in the house with you. If you are not planning on having a person live in the house with you then
they cannot be used to assist you in qualifying for a loan.
Can I build my house on acreage?
Yes you can build your house on acreage, but you might not be able to get financing for it, or it may be much more difficult to obtain financing. Banks view residential construction loans
and mortgages as well – residential. If you build a new house on a 60 acre mini-farm, they feel that the mortgage is financing the purchase of a farm, more so than building a house.
Banks have guidelines for the amount of acres you can build on when qualifying for a residential construction loan. Generally 40-50 acres is a maximum amount. Furthermore, as the acreage size
increases, the amount of money the bank will loan you as a percentage of the total value will decrease. For example, on a typical residential construction project a bank will loan you 90% of
the appraised value. For example, if you house (including the land) appraises for $300K the bank will loan you at maximum $270K. However, if your project involves a house built on 40 acres,
and it also appraises for 300K, the bank will loan you at maximum 75% of the total appraised value. In this example $225K. The loan to value (LTV) decreases as the acreage in increases.
If two people apply for a mortgage, will the bank look at credit scores of both applicants?
In years past this indeed was the case. Recently there has been a significant change. The current policy with many banks is to use the credit score of the person with the higher income. That
means that if the person with greater income, does not meet the credit score requirement (generally a minimum of 620) you will not qualify.
How do self employed people qualify for a mortgage?
Most often, self employed people qualify by applying for what is called a “stated” or “no income verified” loan. This is because most self employed people don’t pay themselves exclusively
through a salary – which generates a W-2 at the end of the year. The payment they receive may be a combination of a small salary plus cash distributions thru the business. Furthermore many self
employed people have many business deductions they are not accounted for. Banks feel there is no good way to get an accurate representation of income for self employed people, like they do with
an employed people that receive W-2’s.
When you state your income, you essentially tell the bank how much you earn. This does NOT mean that you can state whatever you want. Although the bank cannot verify directly what your income
is, they will review your financial records, including your checking account – and they will assess whether the amount of money going through your checking account is reasonable when compared
to your stated income. So for example, if your income through your business is 75K per year, you could, within reason, state a higher amount as a self employed person. This is because the financial
institutions understand that your goal as a self employed person is to have the smallest income possible for tax purposes. In this example, you might easily be able to state $100K of income.
However, if you stated your income at 250K per year, upon review of your checking account statements, the bank would likely say that the 250K is not an accurate reflection of our income.
One other very important issue for self employed people - you MUST have a two year history of self employment income, and it must be in the same field. If you haven’t been working for yourself
for two years, you will not be able to get a loan.
Are there any other things that may be important to know?
Yes there are many, many others. However the more common ones are as follows:
All construction projects require an appraisal and a bank will never loan you more money than the appraised amount - at most they will loan 90-95%. What this means is that in order to loan
you money the bank MUST find comparable sales to determine the value of your new home. If they cannot find comparable sales, they cannot give your house an appraised value – and if the bank
does not have an appraisal they WILL not loan you the money. Practically speaking, what this means is that unique home designs can be a problem if there is nothing like them in the area. For
example a log cabin home in an area with none would be a problem and probably could not be financed. Another example would be a home on 40 acres when all of the other homes in the area are built
on one acre.
In addition to meeting a modest credit score requirement of 620, your credit history must also be clear of bankruptcies, foreclosure, and repossession for a two year period. If you have had
any of these events in your recent past the bank will, most likely, not loan you the money. Judgments and liens are also issues. They do not prevent you from getting a loan, but the bank will
require that these be paid or resolved before the loan can be closed.
Lastly, many people don’t know that a late mortgage payment may keep you from getting a new mortgage. Obviously banks have differing policies, but commonly you will not be allowed to have
any, or at most one, late mortgage payment within the last two years. If you have more that this amount, you will have to wait until your reach the two year mark. Paying your bills, especially
your mortgage, on time is very important.
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Thought of the Day
Not he who has much is rich, but he who gives much.
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