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June 2017

Build Your Dream Home: Construction Loans Explained

Recent shifts in the economy have positive implications for new home construction in the U.S. In fact, MarketWatch reported in May that low home inventory, growth in single-family home construction, and high builder sentiment have come together to create a bright outlook for new home builds. If you have been dreaming of building a custom home for you and your family, now may be a good time to start your research.

Considering construction

The home buying process comes with many factors to consider, and for those who dream of crafting their home from the ground up, the road ahead can seem even more complicated. One of the most important aspects of a home build project is financing, and construction loans are specifically designed to meet those needs. Construction loans are short-term loans that can be used to build a primary or secondary home. Typically, a construction loan is a temporary financing option—anywhere from six months to a year—that helps cover the cost of ground-up construction before the home is eligible for long-term financing, like a mortgage.

Finding financing

If you're ready to take the plunge and begin building your home, start by researching lenders who offer products like standalone construction loans, or construction-to-permanent loans that transition to mortgages when the project is complete. Loans that transition to long-term financing can potentially save you money because there is only a single closing cost associated with the end of the loan term. However, some may opt to keep the construction and mortgage loans separate so they are free to search for the best rates and terms for each type of loan—especially in the current rate environment.

Financing begins with an application process similar to that of purchasing a home. The major difference is that the project scope—comprehensive building plans, estimates, proof of a purchased lot—is required almost right away. Many lenders may require a signed contract with a builder before considering the loan application. This a good time to set up builder and/or risk insurance due to the unpredictability of build projects, which can be delayed or adjusted for a variety of reasons.

Appraisals

Once construction loan approval is granted, the project will be appraised. This is the most critical step of the construction loan process because it determines the final loan amount. Each lender is different, but in most cases, financing will be given for the lesser of either the cost of building the home or the appraised value of the final product. The appraised value is largely determined by reviewing all of the home’s components and then comparing it to recently-sold, similar homes in the area.

For example, consider the cost of building a home as $500,000 and the appraised value as $550,000. If the lender is willing to finance at least 80 percent, it would choose the lesser of the two prices - $500,000 - to reach the total loan amount of $400,000.

Down payment and draws

Another critical component of home construction financing is the equity contribution, or down payment. The equity contribution is usually a percentage of the project's cost or value, whichever is less, which the homeowner pays toward the project in cash. It's important to note that the equity contribution amount is used to pay for project costs first, with the loan money being disbursed only after the equity contribution is spent. Having additional cash reserves available outside of the equity contribution can help offset any unforeseen expenses or additions during the build.

Once financing is in order and the project is underway, the next step is to become familiar with the draw process, which normally follows this system:

  • The general contractor and other project vendors submit invoices to homeowner.
  • The homeowner submits the draw requests to the lender.
  • The lender reviews the requests and ensures that the costs align with the project budget.
  • The lender's inspector is sent to the project site to check that the goods or services invoiced are either on site as promised or completed as described.
  • If all inspections and reviews are passed, the draw requests are approved and the homeowner can draw those funds to pay the invoices.

Building the perfect home

Building the perfect, one-of-a-kind home can be an exhilarating experience—as long as you have patience and a good sense of the process. Construction loans feature several benefits that can help keep the project moving, including regular inspections, flexible financing, appraisals and budget management. While complex, crafting a house from scratch can be rewarding in the long term.

Shelly Addington is vice president and private banking client manager at UMB Bank. She can be reached at shelly.addington@umb.com.

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