When you think of real estate loans, I bet the first thought that comes to mind is a mortgage. The traditional real estate mortgage industry is huge, serving millions of Americans in their pursuit of the “American Dream”.
But 15- and 30-year mortgages are not the only type of residential real estate loans. Another type of loan, based on your existing home, is a line of credit or home equity loan.
A type of loan you may not have heard of, however, is a construction loan.
WHAT IS A CONSTRUCTION LOAN?
A construction loan is a type of loan designed to provide financing to a homeowner, investor, or developer for the purpose of completing a project. Typically, construction loans are short term with the understanding the borrower intends to sell the project after completion or will refinance into long term financing and the construction loan will be paid in full. A construction loan is simply a loan made on the security of a real estate mortgage and perhaps other collateral.
Instead of paying the loan monthly during construction, most construction loans in California and the San Francisco Bay Area provide the borrower with the funds in a separate account known as an “interest reserve” account. Each month the monthly payments are taken from the account so that the borrower will not be required to make payments until the project is completed.
Lenders will usually require the borrower to use a certain amount of their own cash to complete the project. This will economically tie the owner with the project, making it less likely that they will walk away from the project if something goes wrong. Additionally, this will give the lender a cushion whereby if something does go wrong, they are more likely to be able to sell the real estate at a value that would better cover the loan amount.
HOW CONSTRUCTION LOANS WORK
Lenders in the San Francisco Bay Area will limit the maximum loan amount relative to the completed value of the project. This guideline is designed to help ensure that, after the project is completed, if the borrower stops making the payments, the lender can then sell the property and recoup the funds loaned in the construction loan.
The funds from the construction loan are not given to the borrower in a lump sum as is done with a typical home loan. The funds are provided in a process known as a “draw”. The draw is taken from the construction budget to pay material suppliers and contractors. Each lender has their own specific requirements for processing a draw. The borrower is only charged interest on the amount borrowed at any one point.
The loan funds will be disbursed throughout the construction phase of the project and when the borrower has demonstrated the project is 100% complete, any remaining funds in the construction account will be disbursed to the borrower. Lenders will often require periodic inspections before disbursing a draw. This process helps to ensure that the loan proceeds are actually used for the construction project and that the construction process is moving smoothly. The funds are not available to the lender throughout the duration of the loan because the lender has committed these funds and cannot utilize them in any way or earn interest.
WHAT ARE CONSTRUCTION LOANS USED FOR?
The construction funds are used for many types of projects, including a new home, a major remodeling job, rehabilitation of an existing home, purchase of an investment property, as well as acquisition of land for development purposes.
Estimating the construction costs and financing is important. Determining the exact costs for a large project can be overwhelming to the construction borrower. It is important that the construction loan borrower provide the construction lender with a breakdown of the numbers and figure out the entire costs of the project, how long the construction should take to complete the job, as well as determine if they have the means to repay the loan amount in the specified time.
The construction loan funds will be allocated to construction costs and closing costs associated to the loan.
Depending on the type of construction loan, some include entitlement fees, architectural plans, soils reports, permits, topography, water reports, and other necessary testing reports. However, most construction lenders prefer “shovel-ready” projects.
HOW DO I GET A CONSTRUCTION LOAN?
The construction loan requirements vary from lender to lender. Construction loans are short term loans, usually set for as long as the construction project will take to complete. Here in the San Francisco Bay Area, this time period is usually 6-12 months.
To be considered for a California construction loan, the borrower should be prepared to provide the lender with their financial information, as well as a project description, including the address and scope of the project, a full set of plans, a line item budget, copies of required permits, contracts, Builders Risk, and course of construction insurance, property insurance, soils reports and surveys, an Executive Summary, a letter of explanation and exit strategy and other items required by the construction lender.
Any additional information the borrower can provide, such as pictures or information about past projects they have completed, will help the lender in considering the loan request. Collateral and definitive means to repay the loan are often much more important factors to the construction lender.
WHAT ARE SOME PITFALLS OF CONSTRUCTION LOANS?
Of course, as with anything, there are risks and downsides to getting a hard money construction loan. Among the pitfall are:
- Underestimating the costs of the project is the most common pitfall of construction financing.
- Underestimating the time to get the plans approved through the city or county where the project is located.
- Not understanding the time needed for processing the loan underwriting.
- Having a competent, qualified contractor.
- The importance of having a local architect who is familiar with the city and county building requirements for your projects location.
- Selecting lots that are easily hooked up to city services/utilities.
- Not having a good exit strategy for when the construction loan is due and must be paid in full.
As you can see, hard money construction loans are attractive options when it comes to financing your dream home, finishing a renovation, or completing a construction project.