Another title for this post could be “How to make your brain hurt in 60 seconds or less.”

Thanks to the Great Recession and housing bubble, home financing has become a lot more complicated than it once was. This seems to be especially true in new construction.

I met with one potential lender yesterday to walk through my options. This was a preliminary discussion, so I still don’t understand every little detail, but I have the general gist. With this lender, I basically have two options:

Option 1:  A construction loan followed by a totally separate permanent loan (mortgage)

This would involve closing on a construction loan that can cover a period of up to 12 months. That essentially means I would have one year to fully complete construction from the date that the loan closes.  The interest rate for the construction loan would be variable and is based on prime + 1%.

When construction is complete, I would close on a second loan that would convert the construction loan to a traditional 30-year mortgage. The current interest rate for someone with a high credit score is below 4%. This would be for a loan that my lender would then package up and sell off to Fannie Mae or Freddie Mac.

The lender also has its own mortgage loan that it keeps on its books and does not sell off, but it has a much higher interest rate at 4.75%. This particular lender is a co-op, so they provide annual profit sharing to their customers. That means some of the increased cost I would have with this option would come back to me through their patronage program. However, I think the net cost would still be quite a bit higher than a standard mortgage that gets sold off to Fannie Mae or Freddie Mac.

The biggest disadvantage of this option is that because it involves two totally separate loans, there are two sets of closing costs.  That’s thousands of dollars extra I would be spending on… nothing.  I mean, it’s not technically “nothing” as that money is paying for appraisals and recording fees and a bunch of other crap. But none of that stuff adds any actual value to my property, so it definitely feels like spending thousands of dollars on nothing.

Option 2: C2P loan (construction to permanent loan)

Like Option 1, the C2P loan would start off with a construction loan with a variable interest rate equal to prime + 1%. The difference with the C2P loan is that it is a single loan with one closing at the beginning of the project. It automatically rolls over to a traditional mortgage once construction is complete. The interest rate for the permanent (mortgage) portion of the loan is a fixed rate that is locked in from the beginning.

Since the bank is basically locking in an interest rate for up to 12 months, it is higher than current rates. They want to hedge their bets if interest rates go up over the course of that year. If it turns out that rates don’t go up or they actually even go down, I would have the option to pay an $800 fee to lock in a new, lower rate.

The advantage of this loan is that there is only one closing, which saves thousands of dollars. Even if I end up paying the $800 fee to lock in a lower rate, that’s significantly less than what closing on a second loan would cost.

That said, there is one line I came across in the details of the C2P loan that has me scratching my head. There is a 1% construction loan fee that seems to be part of the closing costs of the loan. This is a big chunk of money that doesn’t seem to be required in Option 1. If I understand it correctly, this additional fee significantly raises the closing costs, negating many of the benefits of avoiding a second set of closing costs. I’ve emailed the lender to get clarification on this, and will provide an update when I get an answer.

Loan Requirements 

Both loans have some key requirements:

  • The maximum loan amount is 80% of the appraised value (80% LTV, or loan-to-value).
  • 100% of the project must be completed by a licensed contractor. In other words, there can be no self-builds and I can’t separately contract parts of the project like the site work, HVAC, etc. Everything has to go through the general contractor.
  • I have to spend my portion of the project (20%) before the bank begins to kick in its portion. Since the bulk of my down payment will come from the equity in my current home, I’m still trying to figure out how I would get at that equity and spend it before I’ve sold the house. I have a question in to the lender about this.
  • During the build, I can’t be reimbursed for any purchases I make. For example, if I buy all of the kitchen appliances, the lender will not write me a check to cover that cost. If I want that expense to be part of the mortgage, my contractor will need to buy the appliances. I also can’t pay for appliances and then count that expenditure as part of my 20% down payment because it will be too late in the game. I have to pay my 20% at the beginning of the project, and appliances don’t get ordered until much later.
  • Fortunately, the items I’ve already purchased (lighting, tile, cabinets, etc.) can count toward my down payment. Because everything has to go through the GC, he would have to set up the contract to show these items as inventory deductions. For example (I’m just totally making up numbers here), say the electrical work is quoted in the contract at $20,000. He would then list each of the lights I’ve already purchased with a price, and then deduct that from the $20,000 total. Apparently this exercise is what will allow the lender to then count those purchases toward my down payment.

Pretty complicated, right? The meeting yesterday definitely helped answer a lot of questions, but I still have others that I’ve emailed to my point of contact with the lender. I’ll list the questions here and come back to update them once I’ve received a response.

My remaining questions…

  1. Does the 1% construction loan fee only apply to the C2P loan, or does it apply to both options?
  2. How do I access the equity in my current home before I’ve sold it? I have to live somewhere while the new house is being built, so I can’t just sell my current house to get the money for the down payment!
  3. What happens if the appraised value of the project is less than the cost of construction? In my area, the cost to build is higher than the cost to buy existing property. Could this cause a problem with the loan?
  4. Although it’s certainly my goal to avoid going over budget, what happens if that’s the case? Will the lender automatically increase the loan? If so, up to what amount? Would I need to pay more cash at that point to maintain my 20% equity in the project?

I still want to talk to other lenders to compare loan options, interest rates, and policies. It seems like a lot of this stuff has become pretty standard though as banks seek to mitigate risk as much as possible.

If anyone has gone through a recent construction loan, how was yours structured? Any suggestions on what to do and what to avoid?