Understanding Construction Lending

Summary: This article discusses the various forms of construction financing. It does not cover information related to the purchase of a newly constructed “spec” or “inventory” home that is owned by a builder and transferred to a consumer after completion of the improvements.

Building a custom home has many advantages. You can choose the floor plan and the architectural style of the home. You can also control every aspect of the design and construction to achieve a result that is as unique as you are.

But to fulfill the goal of constructing a new home you’ll face many challenges that purchasers of newly constructed “tract”, “spec”, or “inventory” homes will not. The process of construction financing differs significantly from the process of financing the purchase of an existing residence or a newly constructed “spec”  or “inventory” home.

There are two basic strategies of financing the construction of a new home on a lot or land that you already own or that you will purchase for the purpose of building a newly constructed dwelling. The traditional strategy is referred to a “construction-to-perm” financing and involves a two-step process. The first step involves the temporary financing of the acquisition of the lot (if not already owned) and the construction of the dwelling on the lot. The second phase involves converting this “interim” loan into a “permanent” mortgage loan.  The other strategy is to utilize a single lender (and usually a single loan with a conversion feature) to provide the financing for the interim construction phase and the permanent mortgage loan. This combined financing arrangement is typically referred to as a “one-time-close”.

Construction-to-Perm Financing

A construction-to-permanent (or “construction-to-perm”) financing arrangement is the traditional form for completing a newly constructed residential dwelling. With this form of financing there are three stages: the “pre-approval” or “commitment” stage, the “interim lending” or “construction” phase, and the “permanent loan” phase.

Phase 1. The first phase in this arrangement is to obtain pre-approval for a permanent mortgage loan. This process is similar to the pre-qualification or pre-approval stage of the financing of an existing home (not new construction).  The borrower will make application for and submit all of the required documentation to a permanent lender to obtain pre-approval. An appraisal report for the proposed residence is prepared “subject to completion of improvements”. The appraiser will obtain the architectural plans, construction documents and specifications of materials and based on this information the appraiser will state an opinion as to the value of the home once the improvements are completed. Based on all this documentation the permanent mortgage lender will then approve the application and provide a “commitment letter” addressed to the borrower (and sometimes, the interim lender) stating that the borrower satisfies the conditions for the permanent mortgage loan that will “take out” the existing interim loan.  This commitment agreement assures the interim lender that the borrower has the ability to pay the interim loan in full (from the proceeds of a new permanent mortgage) after construction of the dwelling is completed.

Phase 2. In the second phase the borrower will secure a temporary “interim” or “construction” loan for the purpose of providing funds to acquire the land or lot on which the house is to be erected and to provide the funds necessary to construct the dwelling. If the borrower already owns the land or lot on which the home will be erected, the interim lender (usually a bank) will provide funds to pay-off the balance of any loan secured by a lien on the lot or land. The interim lender will also provide the funds necessary to construct the dwelling.  The interim lender will not disburse all of the funds to the builder or the borrower at the closing. Instead, the interim lender will disburse those funds periodically throughout the period of construction as various phases of construction are completed. The disbursement of a portion of the total interim loan funds as construction progresses is referred to as a “draw”.  There may be as few as three (3) and as many as six (6) draws throughout the construction of improvements.  The borrower will pay interest only on the disbursed portion of the loan proceeds.  An interim loan may be either a fixed-rate or variable-rate loan (usually tied to the prime rate).  The interim lender will usually require the borrower to pay the interim interest monthly or quarterly as it accrues during the period of construction, however, in some cases the interim lender may permit the interest to accrue, not requiring its payment until the interim loan is paid in full.

Phase 3. As the completion of the interim construction phase draws near, the permanent lender will update its mortgage loan file obtaining updated credit, income and asset documentation to obtain an updated loan approval for the borrower.  Once the construction of the dwelling is complete, the appraiser that prepared the original written appraisal report will inspect the property to determine that the construction of the dwelling conforms to the plans and specification on which the original opinion of value was based. After completing the “final inspection” the appraiser will recertify the prior opinion of value. The title documents are also updated during this process and when completed, the borrower will close on the new permanent mortgage, the proceeds of which will be used to pay the balance on the interim construction loan.

The “One-Time-Close”

A “one-time-close” financing arrangement for construction financing combines the foregoing three phases into a single combined process.  With the “one-time-close” transaction the borrower obtains permanent loan approval and closes the interim and permanent loan transaction prior to the commencement of construction. In essence, the lender acts as both the interim construction lender and the permanent mortgage lender. Because of the unique “two-hat” personality of the lender in this type of financing arrangement this type of loan is somewhat rare and is typically provided only by banks or savings banks that have construction lending experience (and also act as mortgage bankers) or mortgage brokers who have wholesale or correspondent relationships with these banks.   Other than the fact that the interim and permanent mortgage are closed in a single transaction, this form financing is actually very similar logistically to the traditional construction-to-perm financing arrangement.

The closing costs associated with both arrangements will be almost identical. Under both financing arrangements an origination fee or construction fee (usually ranging from ½ point to 1 point) and several inspection fees (paid for at each “draw” request) will be paid in connection with the construction phase of the arrangement. And under both financing arrangements the borrower will typically (but not always) pay for construction financing with a variable-rate of interest that will only accrue on the draw portion of the principal amount of the loan as draws of principal are made on the loan.

“Construction-to-Perm” vs. “One-Time-Close”: Which is better?

The only significant advantage to using the “one-time-close” arrangement of financing is that the qualification process is only required prior to the construction phase. With the traditional “construction-to-perm” form of financing the borrower, builder and interim lender are at risk that an occurrence beyond the control of the parties could jeopardize the ability of the borrower to “re-qualify” at the completion of the construction phase. Typically, the only event that would create a problem in this regard is where one or both of the borrowers lose their jobs or have a significant decrease in earnings during the construction of the dwelling.

Conversely, there are numerous disadvantages to the “one-time-close” procedure. The borrower’s qualifications and the underwriting of the application for the “one-time-close” transaction are conducted as if the transaction were a purchase transaction. This means that “value” of the property for determining the loan-to-value ratio and the maximum loan amount will be the lesser of the appraised value or the acquisition cost (the cost of the lot or land plus the documented cost of construction the dwelling). Furthermore, the high-LTV loan programs that typically available on purchases (i.e. 97% and 100% financing) are not available for the “one-time-close” transactions. In fact, most “one-time-close” programs are limited to a 90% LTV.

With the “construction-to-perm” arrangement a borrower may “choose” the most advantageous form of financing. This means that if the borrower wants to utilize a Fannie Mae Flex 100 program to obtain 100% financing he can do so. But even more compelling is the ability of the borrower to “choose’ to have the transaction underwritten as a refinance and thereby utilize the appraised value of the property (as opposed to acquisition cost) to determine LTV and maximum loan amount.

Consider the following examples to illustrate the importance of this element.

Scenario 1. If the borrower can purchase a lot for $50,000, contracts with a builder to construct the residence for $100,000, and the property appraises for $150,000, with the one-time-close program the borrower will typically be limited to 90% or 95% financing and will not have the option of “piggy-back” financing (80/10/10 or 80/15/05) to avoid mortgage insurance. With the “construction-to-perm” option the borrower could choose to utilize a conforming loan program that permits 100% financing such as Fannie Mae’s Flex100 or Community Homebuyer 100 loan program (assuming he otherwise is eligible for the program). Even more importantly, the borrower can utilize a “piggy-back” transaction (75/25, 80/20, 80/15/05, or 80/10/10) to avoid mortgage insurance. Clearly, the option of choosing one of the alternate forms of financing is a compelling reason to choose the “construction-to-perm” form of construction financing.

Scenario 2. A very common scenario is that the borrower can acquire a lot or land and construct a dwelling for less than the market value of the property. In a very common scenario the borrower acquires a lot for $50,000, contracts with a builder to construct the dwelling for $100,000 , and the property appraises for $187,500 at the time improvements are completed. In this scenario, all the limitations of the “one-time-close” in preceding scenario are present (i.e. limited program availability). In a situation where the appraised value exceeds the acquisition cost the borrower will typically choose to treat the transaction as “refinance”. This is because in a refinance transaction the borrower can utilize the appraised value for determining LTV and maximum loan amount. Thus, in second scenario the borrower could obtain a $150,000 to completely pay the balance on the interim financing and would be at an 80% LTV ($150,000 / $187,500). The borrower could choose any loan program, would not be required to use piggyback financing to avoid mortgage insurance, and thereby would also void the pricing adjustments associated with high-LTV secondary financing (e.g. 80/20 and 80/15/05 pricing adjustments).

Because the “one-time-close” loan program is only offered by a small percentage of wholesale and corresponding loan sources the permanent pricing available on these loan programs is typically inferior to those offered by wholesale sources that do not offer the “one-time-close”. Accordingly, the borrower will typically be able to secure a superior permanent mortgage rate and price utilizing the traditional “construction-to-perm” arrangement.

Superior rates/pricing, the flexibility of choosing any suitable loan program and having the option to use appraised value to determine LTV and maximum loan amount will usually outweigh any other perceived advantage of the “one-time-close”.

The only situation in which a “one-time-close” would be the better option is when the one of the borrowers perceives the real potential of terminating his employment or experience a decrease in earnings during the construction phase of the project. This being a fairly rate occurrence, the traditional form of “construction-to-perm” financing will be the better choice for most borrowers.