Construction loans, how they work
Construction to Perm (CTP) mortgages, One-time Close
Construction to perm loans are essentially 3 loans in one, land loan, construction loan and permanent loan in one transaction. These loans have obvious advantages in that you don’t have to close three times saving you time and closing costs. At closing you purchase your land and extended a line of credit predetermined by your construction cost breakdown plus reserves. The construction loan is converted to long-term financing once you receive your CO (certificate of occupancy), from the county.
During construction
Prior to close the bank will want to see permits before disbursing monies. Once you have permits in hand you are off to the races. Typically banks will disburse the soft costs (permits, taxes) plus a percentage, of hard costs (nails and boards) to get building underway. After this, the loan is on a reimbursement basis. Banks will want to insure the work and materials they are disbursing on have been completed or delivered. Inspectors are sent to the project site and report back to the bank disbursement department level of completeness.
Subcontractors may ask consumers for funds up front before starting a job. If you feel the need to do this, do so at your own risk. Unfortunately a few bad apples have spoiled the bunch. Banks experienced in construction loans know this is one of the worst things to do since you may never see the subcontractor or your money again. Banks want to protect their asset and customers by mandating inspections before money is wired.
So how does a consumer do the balancing act between payment and inspections? Credit cards and lines of credit can be used during the lag time to inspection. Some consumers simply let the contractor know that they will be paid after inspection, which seems to be a good policy. The entire process of inspections to money in the bank is usually only a few days. If your contractor is really anxious to get his/her money you will have to foot the bill and accept consequences if their workmanship is sub-standard. If you have the contractor’s money hanging in limbo at least you will have leverage to get the job done if problems arise.
Converting your construction loan to permanent status
Once you received the CO from the county you are now eligible to convert your loan to permanent status. Since you have already signed all your paperwork for the permanent loan at your first closing, you will only be required to sign a few documents. This should come at no cost, re-qualification or formal closing.
Down payments
Down payments will vary depending on loan size and amount of existing equity in your property. In most cases, if you own the land already the bank will accept existing equity in the land as a down payment or will accept monies used for down-payment at purchase. All banks have different requirements depending on the loan size but most use two factors LTV (loan to value) and LTC (loan to costs) to calculate down payments. Ask your lender what to expect for money down early. Don’t get surprised when it’s time to close.
Closing Costs
Besides a down payment, closing costs are the next big question for your lender. Since construction loans are more complex and take substantially longer to close (due to the process of finalizing plans and bids) lenders may charge up to 2% in origination. Other than origination fees, normal closing costs are incurred like typical refinance or purchase mortgages. Date down endorsements, or mechanics’ lien checks, will be the exception. Date downs are periodic title searches conducted to insure no subcontractor has placed a lien on your home for non-payment.
Closing costs are finance charges above and beyond the normal interest you would pay on a loan. Like any mortgage, closing costs should be examined closely but your main concern should be making sure you are working with a professional that has construction loan expertise and treats you fairly.
Know who you’re working with
An experienced loan officer will be your best asset when building your home. Your loan officer should be available when needed, knowledgeable about construction processes and know underwriting guidelines. Just like construction, you measure twice and cut once, the same is true for construction lending. Find the right originator or you may find yourself starting from scratch when things go wrong.
Interest Rates
During construction “prime rate” or “prime rate plus” programs are the norm, fixed or variable depending on your financial situation. If you are hiring a general contractor your end loan rate should be competitive with current rates you see advertised for purchase and refinance money. If you are an owner builder expect rates to be slightly higher for both the construction and perm loans with float downs to current rates at completion.
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