|This is content from a prior version of our website. Please click here to be directed to the updated version of this document.|
Understanding Construction Lending
Summary: This article discusses the various forms of construction financing. It does not cover information related to the purchase of a newly constructed “spec” or “inventory” home that is owned by a builder and transferred to a consumer after completion of the improvements.
A construction-to-permanent (or “construction-to-perm”) financing arrangement is the traditional form for completing a newly constructed residential dwelling. With this form of financing there are three stages: the “pre-approval” or “commitment” stage, the “interim lending” or “construction” phase, and the “permanent loan” phase.
The closing costs associated with both arrangements will be almost identical. Under both financing arrangements an origination fee or construction fee (usually ranging from ½ point to 1 point) and several inspection fees (paid for at each “draw” request) will be paid in connection with the construction phase of the arrangement. And under both financing arrangements the borrower will typically (but not always) pay for construction financing with a variable-rate of interest that will only accrue on the draw portion of the principal amount of the loan as draws of principal are made on the loan.
“Construction-to-Perm” vs. “One-Time-Close”: Which is better?
The only significant advantage to using the “one-time-close” arrangement of financing is that the qualification process is only required prior to the construction phase. With the traditional “construction-to-perm” form of financing the borrower, builder and interim lender are at risk that an occurrence beyond the control of the parties could jeopardize the ability of the borrower to “re-qualify” at the completion of the construction phase. Typically, the only event that would create a problem in this regard is where one or both of the borrowers lose their jobs or have a significant decrease in earnings during the construction of the dwelling.
Conversely, there are numerous disadvantages to the “one-time-close” procedure. The borrower’s qualifications and the underwriting of the application for the “one-time-close” transaction are conducted as if the transaction were a purchase transaction. This means that “value” of the property for determining the loan-to-value ratio and the maximum loan amount will be the lesser of the appraised value or the acquisition cost (the cost of the lot or land plus the documented cost of construction the dwelling). Furthermore, the high-LTV loan programs that typically available on purchases (i.e. 97% and 100% financing) are not available for the “one-time-close” transactions. In fact, most “one-time-close” programs are limited to a 90% LTV.
With the “construction-to-perm” arrangement a borrower may “choose” the most advantageous form of financing. This means that if the borrower wants to utilize a Fannie Mae Flex 100 program to obtain 100% financing he can do so. But even more compelling is the ability of the borrower to “choose’ to have the transaction underwritten as a refinance and thereby utilize the appraised value of the property (as opposed to acquisition cost) to determine LTV and maximum loan amount.
Consider the following examples to illustrate the importance of this element.
Scenario 1. If the borrower can purchase a lot for $50,000, contracts with a builder to construct the residence for $100,000, and the property appraises for $150,000, with the one-time-close program the borrower will typically be limited to 90% or 95% financing and will not have the option of “piggy-back” financing (80/10/10 or 80/15/05) to avoid mortgage insurance. With the “construction-to-perm” option the borrower could choose to utilize a conforming loan program that permits 100% financing such as Fannie Mae’s Flex100 or Community Homebuyer 100 loan program (assuming he otherwise is eligible for the program). Even more importantly, the borrower can utilize a “piggy-back” transaction (75/25, 80/20, 80/15/05, or 80/10/10) to avoid mortgage insurance. Clearly, the option of choosing one of the alternate forms of financing is a compelling reason to choose the “construction-to-perm” form of construction financing.
Scenario 2. A very common scenario is that the borrower can acquire a lot or land and construct a dwelling for less than the market value of the property. In a very common scenario the borrower acquires a lot for $50,000, contracts with a builder to construct the dwelling for $100,000 , and the property appraises for $187,500 at the time improvements are completed. In this scenario, all the limitations of the “one-time-close” in preceding scenario are present (i.e. limited program availability). In a situation where the appraised value exceeds the acquisition cost the borrower will typically choose to treat the transaction as “refinance”. This is because in a refinance transaction the borrower can utilize the appraised value for determining LTV and maximum loan amount. Thus, in second scenario the borrower could obtain a $150,000 to completely pay the balance on the interim financing and would be at an 80% LTV ($150,000 / $187,500). The borrower could choose any loan program, would not be required to use piggyback financing to avoid mortgage insurance, and thereby would also void the pricing adjustments associated with high-LTV secondary financing (e.g. 80/20 and 80/15/05 pricing adjustments).
Because the “one-time-close” loan program is only offered by a small percentage of wholesale and corresponding loan sources the permanent pricing available on these loan programs is typically inferior to those offered by wholesale sources that do not offer the “one-time-close”. Accordingly, the borrower will typically be able to secure a superior permanent mortgage rate and price utilizing the traditional “construction-to-perm” arrangement.
Superior rates/pricing, the flexibility of choosing any suitable loan program and having the option to use appraised value to determine LTV and maximum loan amount will usually outweigh any other perceived advantage of the “one-time-close”.
The only situation in which a “one-time-close” would be the better option is when the one of the borrowers perceives the real potential of terminating his employment or experience a decrease in earnings during the construction phase of the project. This being a fairly rate occurrence, the traditional form of “construction-to-perm” financing will be the better choice for most borrowers.