CHAPTER 10

Construction and Home Improvement Loans

Construction loans and home improvement loans are short-term funds designed to pay for hammers, nails, and labor. After the construction or remodel is completed, you’ll get a permanent mortgage to replace your construction loan.

10.1 WHY WOULD I WANT TO BUILD A HOME? WHY CAN’T I JUST GO OUT AND BUY ONE?

Great questions, but it’s simply a matter of preference. For example, I know a guy who will shave his head before he will ever buy a brand-new car. “Why pay the dealer the 20 percent depreciation on a new car just when you drive it off the lot?” he says. Instead, he’ll buy a car that’s a couple of years old that has all the “kinks” worked out. But I also know a woman who will never buy a car that “someone else has already driven, spilled food in, or had some kid throw up in.” She wants that brand-new car with the brand-new smell with the brand-new warranty, and she prefers to pay the new car premium rather than buying “somebody else’s problems.”

Both are right in their own way. There is no right or wrong reason to buy a new house. There’s a lot to be said for buying brand new. The fixtures are new, the roof is new, the floor is new, the cabinets are, well, new. And you’re the only one to have ever owned it. If there are problems, there are new home warranties and guarantees offered by the builder that take care of them. Buying new is a very different experience from buying an existing home.

10.2 HOW DO CONSTRUCTION LOANS WORK?

Construction loans differ from regular mortgages, but typically, when you get a construction loan you’ll also need to get a mortgage at the end.

Construction loans are short-term loans issued to borrowers who want to build their very own, brand-new house. When the construction loan is up, the construction lender wants the money back, which happens through a permanent mortgage. A permanent mortgage in construction parlance is simply a regular mortgage, as discussed in other chapters. So how do construction loans work?

Borrowers who wish to build begin by getting some building plans and specifications, and then they contact an architect to design the house. After the design work is done, the borrowers contact several builders to get a quote on how much they will charge to build the house and how long it will take. Often this is the longest part of the entire home-building process. When the bid to build comes in way too high, the borrowers go back to the drawing board and scale back their plans. Or when borrowers find out that they can actually build much more house than they had budgeted for, they start adding another room, another story, or a swimming pool.

A key consideration is where to actually build the home. Do you have to find a lot somewhere and buy it first, or do you already own your vacant land? Does your design meet local building codes? Does the house sit far enough away from the street? Is your house too big for your lot? These matters can take a long time to resolve if you’re acting on your own. Even with an architect and a builder by your side, you’ll need some patience.

10.3 DO I BUY A HOME FROM A DEVELOPER, OR IS IT BETTER TO START FROM SCRATCH?

Starting from scratch allows you to build your own home exactly the way you want. Down to the linen closets. When you buy from a builder in a new development, you’ll typically choose from different home styles on several lot sizes. You’ll then pick out carpeting, tile, wallpaper, or whatever else from the builder’s database of offerings. Obviously the design styles are more limited than when you’re building your very own home from scratch, but not so much as to be a bad thing. After all, if a builder didn’t offer nice stuff in all the latest styles and with all the latest home innovations, that builder might have trouble selling new homes.

Building from scratch will take a little longer. You’ll also need to make sure you have land ready to build on. That means putting in utilities if there aren’t any, making sure you’re in compliance with any local regulations or building codes, and ascertaining that you’re not building on top of some heretofore unknown habitat of a Tasmanian lizard that’s on the endangered species list.

When you buy a new home from a builder in a new neighborhood, all those zoning, utilities, and endangered species problems are taken care of. Here you’re not building on land you own, but you are buying both the house and the land at the same time.

10.4 HOW DO I GET APPROVED FOR A CONSTRUCTION LOAN?

Mostly the same way you get approved for any other mortgage. You need good credit and all that goes with it, but the most important thing you’ll need for a construction loan is a commitment letter. This letter comes from your future mortgage lender and promises to pay off the construction loan at the end of construction. Construction loans are for a very short term—just long enough to build the house. They usually only require interest payments during construction, although some construction lenders will let you slide on that as well and have the mortgage pay the construction loan plus interest.

10.5 HOW MUCH DO I NEED FOR A CONSTRUCTION LOAN?

Construction costs are divided between “hard” and “soft” costs. Hard costs cover things like hammers and nails, wood, labor, and anything physical needed to build the home, including the land. Soft costs are closing fees on the property, such as appraisals and title work, along with all the necessary permits and taxes.

Construction loans will also require a hold-back or contingency fund of anywhere from 5 percent to 10 percent. This hold-back is there for any change orders that might occur during the process. A change order is what happens when you change your mind. When changing your mind costs more than the original estimate, the hold-back will help pay for the change. An example of a change order might be if you decide you’d rather have hardwood floors in the baby’s room instead of carpeting, or you want to add a deck that originally wasn’t part of the plan.

TELL ME MORE

To figure how much money you’ll need, simply add your costs together. Let’s say your land cost you $50,000; your plans, specifications, and permits cost you $20,000; the builder needs $200,000 for materials and labor; and your closing costs are $10,000. Your total cost to build would then be $280,000. Add a 10 percent hold-back of $28,000 and your total cost would be $308,000.

Another type of hold-back is used for a specific upgrade or remodel and not held in case there were surprises or cost adjustments during the course of construction. An escrow hold-back in this instance would describe the improvements to be made; the borrower hires a contractor to complete the project while the funds for the improvements are held in escrow by a third party. Escrow hold-backs for specific improvements vary by lender; some won’t allow them while other lenders are more accommodating. Once the improvements have been completed, the escrow company releases the funds to the contractor after a property inspector confirms the job has been successfully completed.

10.6 DOES THE LENDER APPROVE MY BUILDER?

Your builder will need to pass muster, both from an experience as well as a financial perspective. Lenders will review the net worth of your builder, including obtaining a credit report and getting at least three references from other construction lenders. Don’t think that just getting a mortgage approval is all that’s needed. Your builder will need to be reputable and have a record of building good homes. You wouldn’t want it any other way, right? Neither does your lender.

10.7 HOW DOES THE MORTGAGE LENDER KNOW WHAT THE HOUSE IS WORTH BEFORE IT’S BUILT?

The lender will take your building plans and give them to a licensed appraiser, who will determine a future market value of the completed home. The appraiser will look at similar existing homes in the area and pretend that your home is finished and you’re living in it. This appraised value is based upon “subject-to” conditions.

In this instance, the value is assigned to your to-be-built home “subject to” the house being completed and your signing an occupancy certificate. The appraiser will also gauge progress during the construction process and assist the lender in determining how much and when your builder will get paid.

TELL ME MORE

Once you get your permanent mortgage approval, you take that to your construction lender if they’re different institutions. At that point, building begins. But the builder isn’t given your entire $308,000. It’s not a very prudent policy to start handing out lump-sum checks to builders when any collateral is still to be built. Instead, builders are given percentages of the total loan amount during the process until completion.

This is where the appraiser steps in. Let’s say the builder has been working for six weeks and wants more money to either help build more of the house or to be reimbursed for building costs already incurred. The appraiser then inspects the property and determines that “yes, the foundation has been poured and the framing is completed.” Now the builder gets more money, based on the percentage of completion at that stage. For example, if pouring the foundation and framing the house means that the home is 20 percent completed, then the builder gets 20 percent of $308,000, or $61,600. Inspections are made and more money is given to the builder either at predetermined intervals or as the builder requests funds. The way your construction loan is structured will determine what you’ll pay during the construction process.

You won’t make any loan payments at all until funds are given to the builder, and even then you’ll pay only the interest on the amount of funds disbursed, not on the total construction loan amount.

If your construction loan rate is 6 percent and the builder has only received $50,000, then your interest payment would be calculated on only the $50,000. You can make that payment now or let it add up and pay at the end.

10.8 WHAT IF I ALREADY OWN THE LAND? DO I STILL INCLUDE THAT AMOUNT IN THE CONSTRUCTION LOAN?

No. If you already own the land, then instead of coming to the closing table at the end of construction with a down payment, you’ll be able to use the value of the land as your down payment. This arrangement usually only works if you’ve owned the land for 12 months or more. Again, using our previous example, with your land being valued at $50,000 and representing just over 16 percent of the construction cost, you won’t need a down payment. The land equity will do that for you.

There’s another benefit of owning your own land for more than a year before the home is completed: The mortgage lender will treat the permanent mortgage like a refinance instead of a purchase transaction. The benefit here is that the lender will use the appraised value of the home and not the construction cost when determining minimum required down payments and loan amounts. If the construction costs are $258,000 ($308,000 less $50,000 land value) but the appraiser determines that the property is worth $400,000, then you’ll simply “refinance” the $258,000 construction loan, which represents 64 percent of the value of the home. Forget the down payment part.

10.9 WHAT IF I DON’T WANT A PERMANENT MORTGAGE, BUT JUST A CONSTRUCTION LOAN?

There is no requirement that you take a permanent mortgage at the end of construction as long as the construction note is retired. But you’ll have to replace that money somehow, and it can come from any source available to you. You could pay cash to replace the construction note, but this would be a rare occurrence. People who can afford to pay cash to replace a construction loan will usually have paid for the construction out of pocket as the home is being built.

10.10 WHAT CHOICES DO I HAVE FOR CONSTRUCTION LOANS?

There are two common options: a one-time close and a two-time close. A one-time close loan means you obtain construction financing and a permanent mortgage at the same time. A two-time close loan means you first get a construction loan and then get another mortgage at the end of construction. You’ll go to two different closings for a two-time close loan.

A one-time close loan locks in your permanent mortgage rate, which is decided by your original loan. And you pay closing fees just once.

10.11 IS A ONE-TIME CLOSE BETTER THAN A TWO-TIME CLOSE?

You need to compare your choices, but neither will ever be hands-down better each and every time. Yes, with a two-time close you’ll have two different closings, but don’t be misled that your closing costs will double. You’ll have two sets of closing costs, but the costs aren’t duplicated at each closing. You won’t have two full title policies or two different appraisals, for example. Two-time closing costs add up to slightly more than one-time closing costs. The fees are higher, but not dramatically “slap you in the face” higher. The advantage of a two-time close is that if mortgage rates are lower at the end of construction, you’ll get the new lower rates.

The one-time close loan tells you what your permanent mortgage rate and term will be at the end of construction. You won’t need to go through all the paperwork again, other than signing a piece of paper declaring that you’ve moved in. The benefit of a one-time close may also be a disadvantage. Because a one-time close loan guarantees your interest rate at the end of construction, you need to consider what interest rates might do six to twelve months down the road. If interest rates are at or near historic lows, you would want to opt for a one-time loan. If rates are at their peak or at higher than normal levels, you might want to consider a two-time loan.

There is also a twist with a one-time close loan that comes with a float-down feature. A float-down means that whatever your predetermined rate will be, you will have the option of taking the then-current interest rates. This means that if your predetermined rate for a one-time close loan is at 8 percent and rates have dropped during your construction period to 7 percent, you can lock those new, lower rates in as you’re about to move into your new home.

If your one-time close loan offers this feature, it’s hard to beat.

Not every lender offers both one-time close and two-time close loans. All mortgage lenders offer a permanent mortgage. That’s their business. Fewer mortgage lenders offer construction loans. Fewer still offer a choice between a one-time close and two-time close construction loan. That means you can bet that someone who doesn’t offer a one-time close loan will talk it down and make you afraid of it or tell you that there’s no benefit. Take their advice with a grain of salt. Why would they promote a one-time close loan when they don’t offer one? Doesn’t make much sense, does it?

10.12 WHAT IF RATES DROP DURING MY ONE-TIME CLOSE LOAN?

If you don’t have a float-down feature, you can always refinance or modify. No one can predict the future, so you’re not the only one asking that question. You’re right, rates might be higher. Or lower. You don’t know. The one-time loan, while offering a slightly higher permanent rate, also offers the sense of tranquility and well-being that comes from knowing exactly what your rate will be. It takes the guesswork and sleepless nights out of the equation. That offers a lot by itself. But there are a couple of ways to help offset the potentially higher rates inherent in some one-time close loans.

One way is converting to a hybrid loan instead of a fixed loan when you convert from the construction to a permanent loan. A hybrid will offer a lower start rate for a fixed period than what might be available for fixed-rate mortgages. Comparing a one-time loan with a two-time loan can be difficult and confusing, but remember that absolutely no one knows what’s down the road. Should you choose wrong, hey, you could always refinance, right?

10.13 WHAT IF MY BUILDER IS FINANCING THE CONSTRUCTION?

Just get approved for a regular mortgage loan and wait for the house to be built. When you buy a new home in a brand-new development, usually the builder just tells you how much your home will cost, as long as you can provide a commitment letter. No need to worry about comparing a one-time close to a two-time close loan, since you won’t need construction funds. You just need to fret about the interest rate on your permanent loan, which could be six months or more after you’ve signed the contract.

There are also builders who own their own mortgage companies. They will give you a better deal if you go through their mortgage company. Or at least so they claim. Builders who don’t own a mortgage company may have an official business relationship with one, which they’ll encourage you to use. If there is an official relationship between a builder and a mortgage company, that fact must be made known to you up front. Does the builder get a referral fee by sending business to a particular mortgage operation? Such arrangements must be disclosed to you, and you’ll need to sign a piece of paper declaring your awareness of the situation.

TELL ME MORE

Sometimes you get incentives to use a builder’s mortgage company. For example, the builder’s salesperson may offer upgrades worth $10,000 by using the builder’s mortgage company. Not a bad deal, right? Do you think the builder might include the $10,000 in the final negotiated price of the home, or do you think the builder likes you so much you’re getting $10,000 in free stuff? If you’re not sure how to answer that question, simply ask that any upgrade offers be independent of the home’s contract price.

Your great big national-brand builders all have their own mortgage companies, and there may well be some financial incentives to using their mortgage operations. Smaller regional or independent builders usually won’t own their own company, but they’ll use a mortgage broker or banker to refer buyers to. The kicker is that since all lenders get their mortgage money from mostly the same places, you’ll be really hard pressed to find a builder’s mortgage that is a full percentage point lower than anything you can find on the street. Or even a half percentage point.

Builders may also offer to cover some of your closing fees if you use their lender or select from a list of “preferred” lenders. Don’t take this preferred list at face value. You still need to compare rate quotes and fees from nonpreferred lenders as well. Most any lender or mortgage broker can quote you a loan program that pays for some or all of your closing costs.

By increasing your interest rate, a lender can make enough money selling the loan to another lender to pay $2,000 of your closing costs. Any lender or mortgage broker can do that. If the builder’s rates are higher than what you’ve been quoted, you can guess how they’re able to offer you such a deal on closing costs or upgrades.

Another problem is that most interest rate quotes are for a 30-day period, while your construction period may last much longer. When you’re comparing interest rates, it’s important to get a rate quote for the same time period. But if your home won’t be finished for another eight months, it doesn’t matter what rates are today, right? We’ll discuss rate lock periods in more detail in Chapter 13, but look out for lenders who quote artificially low rates knowing they won’t have to honor those rates because the rate is not good enough to cover your construction period. “Mr. Borrower, I could offer you a 4 percent interest rate if you were closing today, but you’re not. Call me when you get a month or two away from your closing and we’ll talk.”

When calling different lenders for a rate quote, don’t tell them it’s for a home that won’t be finished for eight months. Just ask them for their best 30-year rate for a loan that will close in one month. Keep lenders honest by having them quote on the same product.

10.14 DO I HAVE TO USE THE BUILDER’S MORTGAGE COMPANY?

No, but it’s critical to examine the sales contract. There may be a provision that you make a loan application with the builder’s mortgage company, but it’s illegal to force you to use their mortgage company. Most mortgage companies are honest, but it’s the dishonest companies that you need to be prepared for.

Sometimes, in the sales agreement to buy a new home, the contract not only states that the buyer must make a loan application at the builder’s mortgage company, but that if the builder’s mortgage company gets an approval and if the buyer can’t get an approval anywhere else, she is forced to take the mortgage. At first glance, this doesn’t seem to be a bad deal, does it? If all else fails, the buyer can always get approved at the builder’s mortgage company! What if all else did in fact fail, and what if the loan offered by the builder’s mortgage company was terrible?

I recall a buyer who was in that situation. He made an offer on a $700,000 home to be built, signed a contract, and subsequently listed the house he was currently living in. And he put 10 percent down as earnest money, as the contract required. He also needed to sell his current home in order to buy the new home. He couldn’t afford both mortgages.

As the new home was being built, his current house began to languish. He didn’t get any serious offers and he was becoming nervous. He didn’t use the builder’s mortgage company; he used his own mortgage broker, but his loan approval was contingent upon selling his current house. After all, he couldn’t afford two mortgages, so one of the main conditions for the new loan was that his old mortgage must be retired.

Soon, the new home was completed; but his current house hadn’t sold. The builder called and wanted him to fulfill the contract and the buyer said, “Hey, I can’t qualify because I can’t afford two loans. My approval is contingent upon my current house being sold and it’s still not sold. I’m afraid I can’t buy the house after all, or else give me more time.”

“I’m sorry,” said the builder, “but your contract states that if our mortgage company has an approval for you, then you must take it or else lose your deposit of $70,000.”

“Fine,” said the buyer. But when he saw the loan approval, he was stunned: The interest rate was about 2 percent above current market rates. He couldn’t accept that loan, could he? In fact, he was forced to, or else he’d lose his earnest money. The builder’s mortgage company did in fact have an approval. How could they have an approval while the buyer’s mortgage broker did not?

The builder’s mortgage company issued a loan approval. He was stuck. There was no way in the world he could even think of paying both mortgages. He would soon be foreclosed on whichever house he didn’t live in. But his contract did state clearly that “if we get you approved, then you must use us or lose your earnest money.”

If this buyer in fact did take the new loan from the builder’s mortgage company—which he agreed to do in the sales contract—he would have two mortgages that added up to over what he made every month. If he took the new loan, he would be foreclosed on, and quickly, because he couldn’t afford both homes and he was looking at losing his sizable earnest money. He was forced into making a bad decision.

Ultimately he dropped the price on his current home so that it would sell faster, and kept the new home and his new deposit. He got his new home, but he didn’t like how it worked. Nonetheless, the details were right in front of him the whole time.

10.15 WHAT ARE MY OPTIONS IF I JUST WANT TO BUILD ONTO MY CURRENT HOUSE?

That depends on how much you want to borrow. If you just want to borrow $20,000 for a new deck or to redo the master bathroom, then you’d probably want to simply take out a home improvement loan. These loans are second mortgages and carry few fees, although their interest rates will always be slightly higher than first mortgage rates. Some home improvement lenders require detailed plans and specifications as to what you’re building and how much it’s going to cost, which will be compared to your home’s value and any other liens that might be against the property. If you don’t want to go through the hassle of getting building plans and specifications and just want the money to go at your own pace, then simply get an equity second mortgage, or HELOC.

10.16 HOW CAN I BORROW ENOUGH TO MAKE MAJOR IMPROVEMENTS ON MY HOME?

You’ll run into some equity problems if you don’t watch out. Your lender can use the “subject to” value of the improvement when your current equity position in the home isn’t enough to cover a new lien. You have a couple of choices here: One, get a home improvement loan for the second mortgage—usually at a higher rate than a first mortgage—or two, find a renovation loan.

There are various marketing names for these new products, but there are mortgage loans where you can refinance your first mortgage while at the same time obtaining new funds to make improvements. This makes obvious sense only if current market rates are lower than what you might have on your first mortgage. But if rates are lower, you can kill two big birds with one stone. These loans are sometimes hard to find, but when you do find one, it is a very cool deal.

TELL ME MORE

Let’s say you want to refinance your current mortgage of $100,000 and do $45,000 worth of home repairs. You get your plans and specs from a contractor who gives you a bid on the work to be done. Your lender will get an appraiser to assess your property based upon the “subject to” value, just as with any construction loan. Your costs of repairs have a limit compared to the “subject to” value; usually this value is 30 percent. This means that if your improvements cost $45,000, your value can’t be less than $150,000 (30 percent).

Your construction funds are held back by the lender and doled out to the contractor as work progresses. When work is completed, a final inspection is ordered and you’re done. You’ve done some much-needed home improvements and paid for them at the lowest rates available.

Another bonus? These loans don’t have to be for a refinance. Let’s say you find a real fixer-upper but don’t have enough money to fix it up. Use the same loan to purchase the house and to borrow funds to improve the home at the same closing. The same general guidelines for qualifying and the same loan requirements apply both when you buy a home and when you refinance.

10.17 WHAT IS AN FHA 203(K) LOAN?

An FHA 203(k) is a little different from a renovation loan and doesn’t cost as much as a conventional renovation loan in terms of equity required. In fact, the FHA will still allow you to do a rehabilitation loan, or 203(k), with as little as 3 percent down, just like any other FHA loan. Why are they called something weird like 203(k)? That’s the name of the HUD section that sets the loan parameters and guidelines for this product. Again, this is a government deal, so you should expect a name like that.

TELL ME MORE

FHA 203(k) loans have a few more steps that you must complete. Basically those steps are:

Finding your property. No big difference here, but note that the entire acquisition cost, along with improvements, can’t exceed allowable FHA loan limits for your area.

Getting the property inspected by a qualified 203(k) consultant. These folks aren’t exactly falling out of trees, but your 203(k) lender has a list for you.

Getting a bid on how much your renovations will cost. Your consultant will again help you with this step and can assist in finding contractors who can bid on your project.

Having your property appraised “subject to” the work being completed.

Your loan gets closed just like any other loan. It goes to underwriting for approval, you go to closing, and your loan gets funded. A neat benefit of these loans is that not only can you roll your closing costs into your loan, but you may also roll up to six months’ worth of house payments into the note. Not a bad deal. Of course, you might need that money to pay the rent or mortgage on your current home while the renovation work is being done.

There aren’t as many 203(k) lenders as perhaps there need to be. The loan program is sometimes assigned to a special 203(k) loan officer who does little else but these types of loans. A 203(k) loan takes a little longer than a conventional mortgage to process and underwrite, mainly because of the government rules that need to be adhered to throughout the process. All in all, though, the 203(k) option is an excellent loan program designed to help people buy and renovate owner-occupied property.

10.18 I WANT A VA LOAN. CAN I ADD IN MONEY FOR IMPROVEMENTS WITH A VA LOAN?

Yes, the VA has a program called the Energy Efficient Mortgage, which allows the veteran to add up to another $6,000 into the loan amount to be used for energy efficiency improvements. The first step is to have an energy audit performed, typically at the cost of the borrower. The audit will be used to identify which types of improvements could be made as well as document to the lender what the additional funds will be used for. Allowable improvements include:

Thermal windows and doors

Insulation for walls, ceilings, attics, floors, and water heaters

Solar heating and cooling systems

Furnace modifications (but not an entirely new furnace)

Heat pumps

Vapor barriers

The lender will consider the costs of the improvements to be made as well as make a determination that the improvements will lower the utility bills to the point where the utility savings are greater than the cost of the original improvement. Veterans have six months in order for the improvements to be completed, at which point the lender will send an inspector to the property verifying the improvements have been made.