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In plain English, how does construction financing really work?

When clients come into our offices they have all kinds of ideas on how construction financing works. Construction loans, permanent loans and single-closing construction-perm loans are all possible options. And while they all work the same during home construction, they vary greatly at the beginning and the end.

First, let’s see how they are the same.

With any type of construction loan, your payments during the building of your home are fairly small. That is because they’re not based on how much you’ve borrowed, but just on how much the bank has paid out up to that point. For example, let’s say you own your land and the cost of building your new home is $200,000. When you close on your loan, you haven’t really borrowed any money, it’s just been made available. Your builder is paid in instalments or “draws”, based on the amount of work that’s been done on your home at each stage. For the first “draw”, usually banks will pay the builder 10% at the loan closing, or 15% when the foundation is finished. Thus for your first payment 30 days later, you’ll be paying the interest on only a small percentage of the total loan – just on the amount that so far the bank has actually paid out to your builder.

For instance, in the above example if your builder is given a draw of $20,000 at closing, then one month into construction you would have a payment of about $83, or 30 days interest on the $20,000. Of course as construction goes on, and the money drawn out increases, likewise your payments also increase. This is why it is so crucial that construction remains on schedule – not just for your family, but for your finances as well.

Now, let’s take a look at how they’re different.

The biggest difference between the types of loans available is in the closing costs, legal fees and other costs associated with the bank process and the recording of your loan. For example, if you have a construction loan and a permanent mortgage, which is typical, you’ll have two sets of closing costs. Individually each set is not usually as high as those of a standard mortgage – so you won’t be paying double -, but the total of both together will be somewhat higher.

A few Virginia banks have started offering single-closing construction-perm loans, which have been standard in other states for a number of years. With this type of loan, you only have one closing, at the beginning of construction. When the home is complete, the loan simply “modifies’ into your permanent mortgage, thus saving you the second set of closing costs. The closing costs will almost always be higher than for a construction loan, but rarely as much as the total of the two closing costs of the two-loan method discussed above.

Depending on your individual circumstances one method or the other may be better for you.

If you’d like more information on how each loan-type works, on the financing process in general, or some unbiased feedback on what specific area banks offer, please give us a call or contact us.

Often, by the time clients receive our brochure, they have already found a plan they’ve fallen in love with. Whether it’s something they found online, something they’ve had drawn, or a plan they’ve created themselves, we can usually figure a cost to build the home on their property. For a custom builder, pricing that home is a costly, time consuming process. It’s very common for clients to tell us that they’ve gone to other builders, but never received any final pricing. There can be a few reasons – the builder may be booked up for the year, the plan may be more complicated than they want to take on, but it’s usually just that it’s going to take them too much time to price. Here are a few tips that will help you get better results when looking for custom home pricing.

Make sure that your plan has at least the minimum dimensions. The builder needs length and width, dimensions for porches and garages, and room sizes if possible. The more information you can give him the better.
Most clients, rightfully so, have no idea what a particular plan might cost to build. So the first plan they take to a builder could be $100,000 over their budget. If you’re just trying to find out if the plan is within your budget, let the builder know. An experienced builder can give you a very close ballpark estimate in a few hours rather than a few days. If it falls in your budget, or close, then ask him to price the home in detail.
This might be a good time to address the fallacy that a builder’s square foot price has any bearing whatsoever on the price of a plan. It would be no more accurate than asking a car dealer what their price per pound is and expecting to be able to figure an accurate price for your new Cadillac. In our company, all of our standard homes have exactly the same amenities – cabinets, flooring roofing, siding, faucets, etc. – and they still range from $125/SF to $175/SF. That’s because the majority of cost, approximately 55%, in a house is the structure. You also have every builder calculating his square foot price differently. Is he including decks, porches, garages, basements in his square foot price? Or, like Ellis, do they only use the finished square footage? In our calculations a $20,000 garage added to a 1500 square foot house just raised the square foot price by $13. If a builder is going to use the garage to calculate his square foot price, it will drop significantly.
If you have a budget that you want or need stay within, tell the builder. It seems many clients are reluctant to tell a builder their budget. Maybe they fear their budget is unrealistic, but if it is, wouldn’t it be better to know that right up front and save your and the builder’s time? Or they might be afraid that telling their budget could affect the builder’s price. Builders aren’t salesmen. Their price, as the saying goes, “is what it is” – cost plus profit and overhead. So let them know where you need the price to be. First, if the plan you want priced is way over your budget, he’ll let you know and you can move forward with a better plan. Second, if you don’t give a budget, most builders will be polite, but they’re unlikely to price the plan. They fear they’ll spend 30-40 hours pricing a plan just to find out it’s out of your budget and they’re not willing to make that investment. The last – and most important – reason for giving your builder a budget is that they’ll look at your plans with that in mind. If he’s a talented builder, he’ll do his best to stay in that budget. If the home is higher than your budget, he’ll look at ways to decrease cost without affecting the appeal of the plan.
When you’re looking at plans on the internet, do consider the cost of purchasing the plan. Even if the builder, like Ellis, will be making the modifications and drawing the blueprints, he will still have to purchase the plans from the architect to meet copyright laws. If the builder tells you he won’t charge you, or doesn’t need their plans, he’s most likely just “burying” the cost somewhere else.
As I mentioned earlier, the greatest effect on the price of a home is the structure – engineering, roof lines, floor joists or trusses, framing difficulty. So if you hand the builder a 4 page list of every item in the house with manufacturer and model #’s, you can pretty much guarantee you will not get a price at all. If you do, the builder will simply put an allowance in for all of those things and it will be up to you to determine if you can get them within those allowances. He’ll also typically leave the purchase and handling of all of those items to you, the homeowner, since he may or may not be able to purchase them from his normal suppliers.
Start the process early. Most builders will take 45-60 days for a quote (so much for the price per square foot). At Ellis our goal is 7-10 days, depending on the complexity of the plan. If it will take longer, we let our customer know up front. Keep in mind, you’re asking a builder to price 11,000 different parts and pieces with their prices changing every day, figure what he’s going to have to pay 50-100 contractors over 6-8 months for labor to put them all together and ask him to guarantee that price. That’s a lot of variables.

Finally, if you’re understanding the complexity of what the builder has to do – estimating all the pieces and parts that go into a plan, estimating the cost of labor to put all those pieces together and estimating cost increases over 8 months – you’re going to have varying, sometimes widely, prices. Because a builder happens to be the highest price on your home doesn’t mean he’s a “high priced builder”. His estimating on your plans may have just come out higher (or everyone else is low) because none of them have built the plan before and none know the cost for sure. So a word of warning, prices will always vary regardless of overhead or profit margins because everyone is estimating. If you have two estimates at $275,000 and one at $225,000, STEER CLEAR! Of the fifteen to twenty homes we build each year at least three are for customers who had a contract with a builder and it never got started (after a long period of time and a lot of money paid to the bank) because the builder realized he couldn’t build it for the price he quoted. Last year was out of the ordinary. We had six, nearly a third of our customers, who came from another builder who didn’t deliver. My best advice, which I give at all First-time Homebuyers Seminars that I do for builders in Virginia, is that price is undoubtedly important, but reputation is the only thing you can count on. Unfortunately, it’s impossible to compare apples with apples because there are a hundred places for a builder to reduce cost that you’ll never, ever know to ask about. Ask for references from recent customers, check reviews, talk to local banks to see if they’ve had issues. In short, do your homework to find out if the builder has a reputation for delivering on time and on budget. You would do it before you buy a car, do it before you make the biggest investment of your life.

If you would like to talk with one of our highly experienced building consultants about finding the right lot and a free site inspection, building your new home or how financing works, please give us a call in Lynchburg at 434-266-1070 or Smith Mountain Lake at 540-912-0112.

With regard to land, our customers tend to fall into one of three categories: those that already own property, those that that have purchased property but are still paying on it and finally those that are planning to purchase property as part of their entire custom home package. The financing is structured the same way in all cases, but the initial steps differ slightly. In all land situations, you will need at a minimum a “Construction Agreement” with your builder, detailing pricing, specifications, terms and plans in order to apply for financing. A lender will not accept a mortgage application without this agreement as it’s a key component in determining the final value of the property and loan.

All construction financing is based on the total value of the house, site preparation (well, septic, excavation, etc.) and the land. The difference is simply in how much the value of the land counts as down payment (or as the bank looks at it, how it affects the LTV or loan to value).

Let’s just look at the three scenarios separately.

Scenario 1: Owning your land outright
In the cases of owning your land, or partially owning your land, you can often finance even your loan closing costs out of the equity in your property, allowing you to build with no money out of pocket. If you already own your property outright, the bank will still do exactly the same appraisal process. They’ll take your home plans out to your property and the appraiser will estimate the value of the entire property when the house has been built. In that scenario, if the appraiser feels the entire property will be worth $200,000 when completed, and you need $160,000 to build, then it is an 80% LTV. Your land is the same as cash to the bank so you have 20% down.

Scenario 2: Land purchased but not yet owned outright
In a similar scenario, the appraiser says the property will be worth $200,000 when it’s completed, but you still owe $10,000 on the land. In that case you’ll need to borrow the $160,000 to build plus the $10,000 to pay off the land, a total of $170,000, which would then be an 85% loan to value, or 15% down. Still a very good loan for you and the bank.

Scenario 3: Buying the property & the home at once
Buying the property and building the home in the same mortgage? The process is the same, but you would have to bring your normal down payment to the closing. The property is still appraised with the new home on it – let’s stick with the $200,000 figure. In that case the maximum you could borrow would be 97%, so you would need at least $6000 plus your loan closing costs.

Ellis Custom Homes, serving the Smith Mountain Lake area. Building trust one home at a time!

In plain English, how does construction financing really work?

Getting a price on a custom home plan

How does my land (or land I want to buy) affect my financing?