New construction loan details can vary from lender to lender, but I’ll list the most significant characteristics to look for and ask questions about. This will also give an idea of what to compare between lenders.
New construction loans can have one or multiple closings.
Each closing required by the loan, necessitates the involvement of a title company, and there are fees associated each time the title company is involved. This is why I recommend choosing a single close loan.
With the single close option, you only visit the title company one time at the start of the process, prior to breaking ground. After the construction period, the loan automatically converts to a traditional mortgage. No reappraisal needed.
Even with a single closing loan, you still technically have two closing events: the first formal closing at a title company, and the last ‘soft’ closing after the construction phase is complete. See my blog post on this, "Approaching the End of Building and Gaining Possession", for more details.
Most new construction loans require a minimum of 10% down to start the process.
Some lenders charge PMI if you put less than 20% down to start, but some don’t. This is obviously a big deal. Our credit union did not charge PMI with a 10% downpayment. Ask your lender if PMI is charged if the downpayment is less than 20%, and, if so, how much.
Building phase duration may vary from lender to lender.
I've seen new construction loans have building durations of 6, 8, 9, and 12 months. This is significant, because it's the number of months that the construction must be completed in. That timeline starts after the first closing.
Keep in mind, that ground breaking will not allows happen within a month of closing, due to weather, schedules, or other loose ends. For instance, we closed at the beginning od Dec 2022 and broke ground mid-Feb 2023.
Select a duration longer than what you anticipate the construction will actually take. If construction is not complete within this time, I've heard there are interest penalties.
Number of draws allowed on the loan is dictated by the lender.
I will get into the details of this more in the next blog post, the New Construction Series Part 5.3, but this is just the number of times the builder is able to pull money from the loan.
Our lender allowed a maximum of 6 draws on the loan. The builder will need to breakdown how many draws they will make and what they will be drawing for at each point. Just make sure your builder is in agreement with the number of draws they are able to make.
Items needed to close:
Finalized building plans
Builder contact information
Cost breakdown/quote (from the builder)
Draw schedule (provided by the builder)
Appraisal (ordered by the lender)
Homeowners insurance
Prior to closing, your lender will order an appraisal based on your plans.
This is where the financial details can get really confusing. If your total project (home build + lot) appraise for exactly what the build is quoted + the lot cost, then it’s easy math. Your cost = the appraised value, so you put down at least 10% + closing costs.
In this scenario, if you bought the lot in cash prior to closing on the new construction loan, then what you paid for the lot actually goes toward your down payment.
Here’s an example: you paid $50k for the lot and your build is going to cost $500k, according to the builders quote. The lender appraises the total project (house + lot) at $550k. So, 10% down would be $55k, where the $50k lot value goes toward the down payment.
This is a very attractive incentive, but don’t be too optimistic. If you’re building custom and there aren’t great comparisons for the appraiser to pull from, then the appraisal can result in a lower value than the build cost + lot cost.
What happens in that scenario is the money you paid for the lot is essentially consumed by the building cost difference, and that equity vanishes.
Here is an example if the build cost + lot cost is higher than the total appraised value: let’s start with the same scenario as above. You paid $50k for the lot and the build is going to cost $500k. The appraisal determines the total value (lot + potential home) is $500k.
The lender will only allow you to borrow based on the appraised value, in this case, $500k. So, if you’re putting 10% down, which is $50k, then the maximum loan value the lender will allow you to take for the build is $450k.
You have to fund the $50k down payment and the value you had in the lot disappears.
Another scenario: 50k lot, 500k build cost. $520k appraisal. 10% down is $52k and $20k of the lot value goes toward the down payment.
The breakdown is:
total appraised value - build cost = lot value toward down payment
If the build cost exceeds the appraisal value, there is no equity in the lot toward the down payment. Plus, the down payment and the build cost exceeding the appraisal value must be paid at the first closing.
So, you would be putting down at least 10% of the appraised value + the additional build cost beyond the appraised value. If this happens, the lot value is not even considered. It vaporizes.
Here’s that math: the appraised value is $500k but the build cost is $550k. You would have to put 10% of $500k down at closing, $50k, plus another $50k to account for the higher building cost ($550k - $500k = $50k).
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