To many potential homebuyers, the idea of building a home for their specific needs and desires sounds ideal. The process of applying for, and closing on, a construction loan for a single-family home, however, requires a much greater commitment of time and financial resources compared to financing an existing home. The primary reason is simple. Banks prefer to lend on an existing tangible asset.
In prerecession days, small builders had greater access to capital, but now they must frequently put the onus on the buyer — and thus on mortgage originators — to obtain construction financing. If that buyer has poor credit or a credit-history glitch, the home sale could be lost — along with the originator’s time, effort and commission.
If you work with any small builders to help them finance the building and selling of homes, you know it can be difficult to secure that financing. Banks and lenders have tightened their lending practices, and lending on spec homes requires due diligence and analyzing the balance of supply and demand for a particular market. A decade ago construction loans were fairly easy to acquire, so builders didn’t necessarily need help from loan originators. The mortgage meltdown during the housing crisis left several construction lenders holding notes on partially completed homes, however.
Some builders simply walked away from these unfinished homes when values plummeted. Many construction lenders took immense losses as a result. Many lenders, whether burned or not, are now hesitant to provide construction financing for single-family homes. This is where residential mortgage originators can help.
Traditional loans
Traditional bank-funded residential construction loans are typically short-term loans with a maximum one-year term and feature variable rates that move up and down with the prime rate. The rates on this type of loan are higher than rates on long-term mortgage loans. To gain approval from the lender, a builder will need to supply a construction timetable, detailed plans and a realistic budget. This is sometimes called the “story” behind the loan, a term more common in commercial property loans.
Construction loans use fund-control or construction-reserve accounts for disbursing predetermined funds from the lender to the borrower once the corresponding — and agreed upon — construction tasks have been completed. The line-item budget specifies the construction tasks to be completed and the amount of funds that will be dispersed upon completion.
There are many pros to using traditional bank loans, especially lower interest rates, but there also are many cons. Most banks, for example, require a 20 percent deposit, or a maximum loan to value ratio of 80 percent, for the project. A borrower also needs a good credit score to obtain a construction loan — typically a FICO credit score of 680 to 700 minimum — and proof of strong, verifiable income. In addition, it can take a bank 60 to 90 days or more to close a deal. There are no “quick closes” with a bank.
Banks also will pull the credit on the builder for each deal brought to them. There is no “one-time” credit check. Traditional banks will review the builder’s financial history and will have a high bar for those that are self-employed. Builders specializing in single-family homes also must contend with the fact that many banks won’t lend on more than four home-construction projects at one time.
Borrowers must pay back the entire hard money loan at the end of the term or points will be added, and the loan may balloon.
In order to receive a bank construction loan, builders must complete long applications requiring information about their finances, credit history, employment history, debt ratio, income, personal assets, liabilities and more. Banks also will want to make sure any property to be built meets their standards. Once that process is completed, a bank can take an additional 30 days or more to check and review the information received.
Bank financing can be an important part of a builder’s funding strategy, but because of the 20 percent downpayment many banks require, it cannot be the only strategy used. That 20 percent downpayment per deal adds up quickly, depleting a builder’s working capital and limiting the number of homes they can finance and build at any one time.
With the Great Recession came new banking regulations. With these regulations still lingering for most small community and national banks, the frustration is apparent with builders and investors, and many are now turning to private, nontraditional capital — called hard money — as a viable solution to meet their goals.
Hard money
Hard money loans are given to individuals or businesses by private lenders or groups of lenders to finance real estate purchases or construction. These loans are used more often in commercial real estate than residential, but they can be used for the construction of single-family residential homes in many instances. A residential loan originator who has a relationship with a reputable hard money lender may be able to help builder clients and other borrowers who are looking to build a home.
These hard money lenders provide asset-based loans that are secured by the value of real estate property. These loans differ from other loans because the hard money lender makes financing decisions based primarily on the value of the property being constructed or purchased rather than on the borrower’s credit and financial history.
There are many pros and cons of using hard money for new construction. Let’s look at the pros first. Your clients can receive funding quickly, often in a matter of days or weeks, compared to months with a typical bank loan. The credit rating of the borrower or the builder is seldom an issue with most hard money lenders.
In addition, a borrower typically makes interest-only payments each month on a construction loan — and only on the portion of funds dispersed as of the payment-due date. This eases the financial burden during construction. The reason for this is that the lender only disperses funds at intervals, when the builder takes draws to cover materials and to pay for labor completed.
There also are several cons to using hard money that you should make your borrowers aware of before they proceed. Interest rates are typically higher on hard money construction loans than commercial bank loans — and can be up to 15 percent or higher.
Many hard money lenders will only lend to businesses or entities, not individuals. Most hard money construction lenders also will only finance “conventional” homes located in large metropolitan areas at a moderate — $350,000 to $500,000 — price-point. They are not willing to take chances on properties that might be difficult to sell should they need to take possession.
In addition, the whole project will not be funded through a hard money lender. Most will finance only 65 percent of the completed value of the project. That means your clients will need to have more than a little “skin in the game.” This equity can include the value of the land if owned by the borrower.
Most importantly, borrowers must pay back the entire hard money loan at the end of the term or points will be added, and the loan may balloon. Some hard money lenders offer bridge-to-permanent financing and most will require an exit strategy. This is an opportunity for the loan originator who helped broker the original hard money loan to put together a conventional mortgage for the borrower to replace the short-term construction loan.
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Building a relationship with a hard money lender can give residential loan originators the ability to help borrowers who want to build their own homes and can even help them expand their clientele to include small local builders. All it takes is the knowledge of how these deals get done.
When dealing with hard money, you have the ability to present your client’s planned transaction to an individual who can make allowances for imperfect credit. There are no black-and-white guidelines, like when dealing with a bank. If the deal makes sense, based on the merits of the transaction, a loan can be structured to meet the needs of your borrower.
