Financing A New Construction Home
So you’ve decided you want to build a custom home? Congratulations! If you are like most people, instead of paying cash for the new property and the construction, you will want to finance your home. Unlike the normal home buying process, new home construction finance is a difficult and complex process that many lenders won’t do. We spoke with John Francomacaro, Vice President and Senior Loan Officer of George Mason Mortgage about how to finance a new construction home, and he had some great insights to share.
Open Land v. Tear Down
In Northern Virginia, open land is a scarce commodity. If you want to live in Arlington, McLean, Fairfax or another location closer to the District, you are more likely to find a property with an existing house that is decades old – i.e. a “tear down.” When it comes to finance, there are differences between open land and a tear-down. Open land will require a 35% down payment. Depending on the amount of the financing, a tear down will require only 25%. Given property values in Northern Virginia, this can represent a significant difference.
In addition to being more readily available in Northern Virginia, tear down properties will be more expensive than open land, but they come with several advantages. First, the utilities like water, sewage and electrical are already installed in the property. Second, the land has already been cleared of trees. Finally, the basement of the existing structure can be reused, which cuts down on excavation. All of these represent major time and cost savings by going with a tear down that will offset the purchase price.
Getting Approved for the Financing
Unlike an ordinary mortgage, a new home construction loan represents risk to the lender because the loan collateral, house on piece of land, is a future value. The cost of construction plus cost of land (hard-costs) may not appraise at 80% loan-to value. Construction lenders typically require 20% down of the hard-costs at the purchase date of the “tear down” or land. Lenders have additional requirements.
First, the future homeowner has to work with their architect and builder to generate detailed plans and specifications for the construction, including itemized costs or appropriate allowances for every aspect of the construction. Along with the contract of sale of the property, these plans and details will be included in the closing process. In other words, the transaction won’t occur, if the buyer and the architect/builder aren’t prepared in advance. Working with an architect/builder like AV Architects & Builders cuts down on the parties needed to get to the closing and assures that the plans and cost details are accurate and acceptable.
Second, a lender will require a more complex, and costly, ”To be Completed” appraisal of the property. This appraisal has to look at the present value of the property as well as estimate what the property will be worth once the construction is complete. The appraiser will need the same plans and details that the lender will require at closing. Needless to say, this appraisal is more expensive.
The Finance Process
New construction home loans consist of several moving pieces. The total amount financed is up to 80% of hard-costs (property purchase cost + construction costs = hard-cost). The borrower comes to the purchase closing table with this 20% balance. A big number—bigger than a simple 20% down payment on the tear down purchase. It can sometimes cover the total purchase cost. In most cases more cash is needed, so the 1st draw (the only draw to the seller) is funded by the lender. The remainder of the loan, is disbursed to the General Contractor in six or seven additional draws upon completion of design/construction milestones. The construction phase of the loan is typically 12 months with interest only, paid monthly by borrower, for funds used, i.e. draws taken. Draw Requests initiate funds from lender to the General Contractor. At each construction distribution, the title company records a modification to the increased mortgage lien on the property. According to John Francomacaro, “We usually see six to eight total distributions throughout the course of the transaction, so it’s important to have a responsive title company to handle the recording process.”
At the end of the 12 month construction period, the total amount of the debt is modified into the permanent mortgage; 30 year principal and interest payments. Under a one-time close loan structure, the same construction rate remains locked for two to six additional years depending on the Adjustable Rate Mortgage loan terms. In a two-time close loan structure, the interest rate for the 30 or 15 year permanent loan is locked at construction completion and is usually a fixed rate mortgage. “It’s a lot a like a full refinance of the mortgage, including a second round of title insurance, but there are some important costs that don’t show up in the second closing,” says Francomacaro.
There are few lenders that specialize in financing a new construction home loan. George Mason Mortgage is happy to work with clients to make their custom home dreams come true. To learn more about the financing process, contact John Francomacaro at George Mason Mortgage. To learn more about building your dream home, contact AV Architects & Builders to set up a consultation.