We didn't expect any problems. That was the first problem.
You see, Kris and I have excellent credit -- we pay our bills on time, had more than thirty percent of our project cost saved, and weren't carrying any debt other than our existing mortgage. We both work, but had made sure that we could carry the mortgage on the new house on just my income. Even our mortgage representative at our bank thought it would be smooth sailing.
So, what caused problems? I'll get to that in a minute.
As a general rule, institutions that allow you to borrow large sums of money do so on the premise that you'll be able to pay them back, or, failing that, that they can sell something to recoup their cash. It's that second clause that makes construction financing different from a regular mortgage: credit issues aside, if you're buying a house that's already built, the bank could recover their cash even if you were to default on the very first payment. With a construction loan, the bank can only imagine what they're paying for, based on a whole bunch of paper.
The credit rules are typically a little stricter as well. At our bank, for example, you must put up at least 20% of the project cost yourself, rather than the 5% or even "nothing-down" mortgages that are becoming more common. Other requirements are pretty simple: the mortgage payment itself, plus all taxes and insurance, shouldn't be more than some percentage of your gross (pre-deductions) income; and your total monthly payments on all debt (car and student loans, credit card, and so on) cannot be larger than some other percentage of your gross income. The mix varies both from bank to bank and also dependant on your credit history. Someone with good credit will likely need to keep the mortgage payment to less that 25-27% of your gross income, and total debt to less than 35% of your gross income.
There are many places online that have "financing calculators" that will help you figure out how much house you can actually afford. I've listed several of them in the resources section below.
One thing you'll find, at least if you're like us, that the bank might allow you to borrow enough money that the resulting monthly payment looks unaffordable, or at least more that you're willing to part with every month. In that case, you might want to work backwards, deciding how much you can afford to pay per month, and figuring out how much of a mortgage that translates into.
Finally, the bank will want to know what you're building, who's building it, and be reasonably assured that your new home will be worth what you're paying for it and that the house will be completed. If you're working with an established contractor, this isn't likely to be an issue, provided they haven't had credit issues themselves. If you're acting as your own general contractor, you'll also probably have to prove to the bank that you're capable of getting the house built yourself.
We also had other issues to deal with, as will most people. We had an existing home, and although we weren't counting on the profits from it's sale for any of the down payment on the new home, would we have to sell it and discharge the mortgage prior to being approved for a construction loan? If so, where would we live? Some of our down-payment was tied up in stocks and stock options -- would we have to sell those as well, and incur the tax consequences?
With regard to the stocks and options, we decided to sell and pay the taxes, as we knew their approximate value and wanted to be absolutely sure that we had real cash-in-hand. That turned out to be a very good choice, as the stocks were in high-tech companies and nearly all of them have seen their value drop through the floor in the stock market bloodletting that has gone on for most of this year. Our bank would have required us to sell the stocks eventually as well, but only as real cash would have been required to pay bills.
Normally, you don't have to sell your current home just to get approval on a construction loan. If you are dependant upon the proceeds from its sale, most lenders will allow you to take a "bridge loan" that is effectively a line of credit against your equity in your home, giving you access to that money. This does have some risk to it, as you have to be sure to get what you think the house is worth when it is sold and account for your broker's fees. We weren't planning on doing this, but fate intervened.
We had applied for a loan that was fully 80% of our total project cost, including our land, even though we were planning on putting as much as 30% down. We figured that this would give us a good buffer against cost overruns, so that if we wanted to go for a particular upgrade we had money available without having to go back to the bank for permission. Given our credit, even the bank didn't see any problems with our plan.
Until they appraised the house.
Our appraisal came in tens of thousands of dollars lower than the project cost, due to a lack of comparable sales (recent sales of similar homes for similar amounts of money.) To hear the appraiser tell it, we were building the most expensive home in the development, possibly in town.
Freetown, Mass., is a rural community: old farmland and forest, lots of smaller homes, little real zoning, and few developments. It's also a good drive to Boston. One of the side effects of this is that there's a real tendency for people to build homes there and never move out of them, so not a lot of homes change hands every year. Most of the homes in town that are comparable in size and features to ours are in one of two or three neighborhoods, including the one we are building in. These neighborhoods are also different in that they are all custom-built homes.
A simple drive through the neighborhood in which we're building shows that we're not building the most expensive home in the area, although we're probably in the top 25%. That was actually something we considered very carefully when buying land. Appraisers, however, can only go on public records, and for nearly all of the twenty or thirty homes in the neighborhood the only public record was the sale of the land itself. In Freetown, this is a trivial amount of money compared to construction cost. To make matters worse, only three homes had ever changed hands from the original owners, and those had all been "distress sales" -- one divorce, one person moving due to a job change, and a death -- so the amounts they sold for may be suspect. The amounts paid most of these homes to be built is really known only to the contractors, the owners, and their banks.
This is apparently a fairly common problem, and, although it resulted in some confusion, we eventually got approved for the loan by decreasing the loan amount to 80% of the appraised value using the equity in our current home as additional collateral. We've since sold that house, which even got us a little of our "buffer money" back, and are living with Kris' folks during construction. We also had the option of still borrowing the full amount of money using two loans, one of which would effectively have been an equity loan on the new house, so even for folks without the ability to borrow less this would have been a solvable problem.
Unlike a regular mortgage, your bank doesn't just take your down payment, hand your contractor a big check, and call it a day. The money is paid out in multiple "draws" during construction, corresponding to specific things being completed by your contractor, usually with a little bit held back until the very end of construction and the lawn being seeded. These draws are actually paid to you, and not directly to the contractor. You remain responsible for paying the contractor.
This means that you hold on to your part of the money until it is needed. For each payment, the expectation is that the bank is paying for its part of the work and you make up the rest. Because the bank and your contractor likely have different ideas as to how much each phase of construction costs, the percentage you'll pay out will vary from draw to draw, but it all adds up in the end.
Finally, the contractor will likely want more fine-grained progress payments than the bank pays out. You have two options for dealing with this: more bank draws or paying out from your own cash. Most banks will allow more than their normal number of draws, usually for a hundred dollars or so in extra fees for each draw. Because we have cash in hand, we're avoiding the extra fees by paying the contractor out of pocket, replenishing our accounts when the bank issues a check. This will keep us to a minimal number of extra draws, although we may still need one near the very end of construction.
Getting the bank to issue a check is simple: when you and your contractor believe that all the work for a certain "phase" is done (for example, the house is fully framed and house-wrapped, the roof is shingled, and windows and doors are installed, making the house "tight to the weather") you call the bank and ask for the respective draw. The bank sends an inspector out to the site to verify that the work is complete (thus the fee) and, if everything is in order, issues a check to you. You then pay the contractor according to your contracted amount for that construction phase.
Finally, once you've actually borrowed money, you'll be making payments, but only on the interest of the amount you've borrowed to date. You won't be making principal payments on a construction loan, ever.
Until recently, most construction loans were non-convertible: the construction loan was treated as a 15- or 30-year loan for purposes of calculating interest, but it would have a balloon payment of the full amount that you'd borrowed after some fixed span of time (usually 1 year.) You would then have to go out and get a mortgage on the completed house, and make your balloon payment with that mortgage.
More recent loans, ours included, are "convertible" or "all-in-one" construction loans. For the first year, we have a regular construction loan. During that time, we make only interest payments. After the "construction phase" is done, it becomes a regular mortgage, but one whose payments are figured for a 14- or 29-year period rather than 15- or 30-year period. These make the process a little bit easier, as you don't have to go through the application process twice.
Hopefully, you'll find this information useful -- we couldn't find anything like it online when we were planning. This is also likely to be the last article that I'll be writing as a "how-to" article: the rest will cover specific decisions we've made or things we've done on our own project in more detail, and the first of these should appear soon.
Resources
Yahoo's List of Mortgage Calculators