Construction loan vs. land loan vs. conventional home loan?
Very often we Abundance get calls from clients who want a construction loan to buy a piece of property for future construction, but no approved plans yet. That’s pre-mature. Construction lenders will only consider a loan when you have nearly approved building plans, shovel-ready, so to speak.
Until your building plans are nearly approved, you have a few options:
Scenario #1 - If you are buying a property with a safe & habitable structure that you plan to expand or re-build, consider purchasing the property with a conventional home or investment property loan first. This yields the lowest carrying cost while you get your building permits. We Abundance have access to many lenders to compete for such loans, closing escrow in 28 days or less.
Scenario #2 - If you are buying a property with a dwelling that is not habitable (e.g., mold, foundation, heating issues) – consider a private lender’s fix & flip loan. Yes, interest rate will be higher than conventional loans available in Scenario #1; and these loans often have balloon payments. This is a great option if the sellers want “quick close” without any financing or appraisal contingencies. It’s even better if you can negotiate a slight discount in exchange the certainty of a “quick close.” We Abundance offer fix & flip loans with only 3-mo minimum interests and can close escrow in 14 days or less.
Scenario #3 - If you are buying a piece of residential zoned lot, with no permitted dwelling, then you will need a land loan. After the challenges of the Great Recession, very few lenders offer land loans. The few who do require residential zoning and utilities to the lot line, and 50% or more down payment. Yes, we Abundance offer land loans to financially strong borrowers who have the capacity to take it to the finish line.
Scenario #4 – If you are buying a property that has nearly approved or expired plans, and you plan to start construction very quickly, then yes, start with a purchase-and-construction loan. The process is as outlined below, with the lender funding a good portion of your purchase as the initial draw.
Scenario #5 – If you are buying agricultural zone land, and expecting to re-zone or sub-divide, your lender choices are very limited. You should expect to need 65% down payment, if you can even find a lender. In such cases, you may want to negotiate a “seller carry” for 2 to 3 years, as you go through the zoning, subdivision, and permitting process. While sellers often prefer a clean sale, without any “seller carry” loans, many landowners know their buyers’ choices are limited and may be willing to negotiate.
Planning Tip #1 – If your property has a habitable structure, or can be readily made habitable, it may be worthwhile to rent it out while you take the project through the permitting process. This helps with your cashflow and with housing shortage in your community. And it may change the tax nature of your project (e.g., Rental for potential 1031 exchange tax deferral? Or long-term capital gains if you choose to sell). Talk with your CPA or tax advisor.
Planning Tip #2 – Talk with licensed general contractors (GCs) and talk with us Abundance to set a realistic budget before you buy the property or start on the permitting process. Construction lenders are thorough with their underwriting (see below). You don’t want to be stuck with a piece of non-income producing property or spend valuable time and money ($30,000 to $50,000 on soft cost) if you cannot qualify for a construction loan.
Put Together a Realistic Construction Budget
If you are buying a project with approved building plans, or if you’ve just submitted your construction drawings to the City / County for building permits, you need to put a realistic budget together and get your financing in order before you break ground.
Construction lenders will want to see that:
1. The project is financially viable.
2. The builder and owners are experienced enough to navigate permitting, building inspection, and supply chain issues; and
3. The owners are strong enough to get permanent financing after the construction is done.
A realistic budget should include at least the following:
Soft cost – architect, engineers, surveys, Title 24 study, impact fees
Off-site improvement costs (e.g., sidewalk, street lamps)
Demolition and site prep cost
Vertical construction cost
Finishing material cost
Hardscape, landscape, driveway costs
Holding costs – property tax, builder’s risk insurance, interest reserve
Contingency – 10% to 15%
Planning Tip #3 – Don’t rely on your architect’s estimates for budgeting. Talk with licensed GCs in your local area, whose quality and workmanship meet your expectation. They will have the latest scoop on construction cost trends and labor costs.
Planning Tip #4 – For realistic holding cost, pad your schedule by 2 to 3 months for permitting, and 4 to 6 months for construction. This will give you greater holding power to make good decisions. You don’t want to be running short on funds and sacrificing quality.
Where to Find Money?
As mentioned earlier, you should line up all your construction funds, including buffers and reserves, before you break ground. If you run short on funds after construction has started, very few lenders would be interested in the loan. Lenders don’t want to work with someone inexperienced; and they worry about “broken priority” in the lien position.
Here are some typical sources of construction funds:
1. Your own savings – If you plan to liquidate stocks for construction, make sure your account for market fluctuations and capital gains taxes when you trade stocks.
2. Your home equity line of credit (HELOC) – If you have a healthy HELOC, this is a good, low-cost source. Just make sure you have the ability to qualify for a re- financing after your construction. Get yourself pre-approved.
3. Construction loan – Most construction loans will be in the ballpark of 60% to 65% of the “As Completed’ appraised value, with some of that used to pay off any and all outstanding mortgages so the construction loan can be the first mortgage (also called “first deed”). The construction lender will also deduct from that amount the interest reserve for the holding period. You need to come out of pocket for any construction cost shortfall.
Planning Tip #5 – Do not break ground or have any material delivered on site until after your construction funds are all settled – closed escrow. Some lenders and title insurers will do a job site inspection the morning before they fund the loan and close escrow. If they find any signs of work, they will consider that a “broken priority” to their lien protection. They will deny the loan or require you to post “Stop Work” notices for 90+ days.
Planning Tip #6 - Don’t use your 401K or IRA as construction reserves. While some lenders allow this, this is a really bad idea. Your 401K and IRA are for your retirement and protected in bankruptcy court. Don’t risk it.
How to Apply for a Construction Loan?
We Abundance have access to both bank construction loans, and private money construction loans. Bank constructions always have lower interest rate, with interest accrual based on amount drawn. Banks can be skittish, with red tapes throughout the entire process – for example, they don’t generally allow owner-builders. Private lenders are more flexible. That flexibility comes with a price. We Abundance will explore bank construction loan options for you and also offer you our in-house private money loan options. We’ll put them side-by-side so you can make an informed decision.
Here is what we need to start underwriting the file:
Project plans – e.g., size of the home, # of bedrooms, baths, garage, where it is in the permitting process, engineering drawings, elevations
Project financials – construction budget (contact us Abundance for sample), sales projection (if you plan to sell), timeframe, carrying costs, reserves
Proposed construction contract, with builder’s license and bond details
Material finishing list (contact us Abundance for sample)
City/county off-site development requirements (e.g., trees, sidewalk, street lighting, sewer connections)
City/county impact fees
Personal financial statement of the borrower principals (e.g., anyone who owns more than 25% of the ownership entity)
Last 2 years’ tax return for the entity, and the borrower principals and/or guarantors
Planning Tip #7 – Construction lenders require “As Completed” appraisal based on your proposed building plans, finishing material, etc. There is a shortage of qualified “As Completed” appraisals. Budget 4 to 6 weeks for this.
Planning Tip #8 - Give yourself 3 to 5 months to secure a bank construction loan. If bank construction loan is not viable for your project, then you’d still have time to evaluate private money construction loans.
Construction Loan Approved. Now What?
Once your construction loan has been approved, you will need to provide the following to your construction lender:
Fully executed construction contract
Final budget for the construction draws
Builder’s risk insurance policy – covering the builder
Course of construction insurance policy – covering the property owner
Most lenders will only release funds based on % completion. For example, if you had budgeted $80,000 for foundation, and you’re only 80% done at the time of your construction draw request, the lender will release only $64,000 of your line item for foundation at that draw. And if your foundation actually costs you $90,000, you’ll have to pay that additional $10,000 out of your own pocket.
Some lenders allow for an initial draw for soft costs already paid, and for the initial material purchase. Not much money but may help you get started.
Many bank construction lenders set a maximum timeframe for the complete draw down of your loan to around 6 months. Consider giving your builder a time-based incentive, if they agree to it.
Planning Tip #9 - Shop early for your Course of Construction insurance policy. Yes, you’ll need it in addition to your GC’s builder’s risk policy. Make sure you ask for a “policy specimen” and review it carefully before you pay. There are a lot of exclusions in these policies, and often a long “minimum earned premium” period. If it’s the wrong policy, and you cancel the policy after you receive the policy binder 20 or 30 days later, you’ve wasted that minimum earned premium. It took us 6 months to get one for our recent project. Contact us Abundance for our insurance agent referrals.
Planning Tip #10 – Get organized. For each construction draw, your construction lender will want to see “Paid in Full” invoices and lien releases from your GC and possibly your sub-contractors. Your upcoming permanent financing lender will also engage title officer to verify that all GCs and subs have been paid, with unconditional lien releases. You can save yourself a lot of time by maintaining good records of these payments and releases.
Almost Done with Construction? Let’s Work on Your Permanent Financing!
If you are not planning to sell the finished house immediately, we recommend starting work on your permanent (30-yr) financing 2 months before you complete the construction. The new lender will require another appraisal, and “certificate of occupancy” (that you’ve passed all final inspections) before they release the funding.
Planning Tip #11 – Start working with utility companies early, especially PG&E. Even if you had both gas & electric on site before you started construction, the City / County will likely allow only one utility service before you receive your certificate of occupancy; and the other once you pass all inspections. Utility companies are back-logged, especially during wildfire season. Plan ahead and follow up diligently.
Planning Tip #12 – Remember to get yourself pre-qualified for the permanent financing before you start your construction loan and continue to improve your monthly income and expenses. You don’t want to quit your day job during your construction process, and risk not getting a good, low interest-rate permanent financing at the end of the construction. Remember, construction loans have balloon payments and can be expensive to extend beyond the maturity date.
Final Thoughts…
The benefit of financing big renovations with a construction loan, rather than a personal loan or a home equity line of credit, is that you’ll have stronger holding power to complete the project. A bank construction loan is always preferred, if you qualify. Sometimes a private money construction loan is more advantageous, depending on your own financial situation and timeline.
We Abundance are here to help you through the entire project of your construction. Make us part of your core team for the project.
See our client testimonials => https://www.abundance99.net/testimonials
Subscribe to our blog => https://www.abundance99.net/blog
Subscribe to our Youtube channel => https://www.youtube.com/@abundance99inc.3
Comments