If you decided to resort to the services of a bank in order to get the construction budget for your custom house project, you need to be aware of the fact that the entire process is intricate, requires careful planning and math skills. Do not think that you will easily receive the money that you ask for. The lender is minutely building the bank’s construction budget in conformity with several criteria. The article is destined to walk you through it so that you can understand and see the whole matter from the bank’s perspective.
The lender’s underlying interest when offering a construction loan is to have every dollar covered on the day that the borrower closes the deal. The scenario of taking back the property when it is partially built because the customer defaulted the program is the least desirable. No longer a land, neither a completed house, the property would take quite some time to be sold. In the eventuality of this situation, the lender has to delineate an appropriate construction budget that would include enough funds to be used in order to finish the project if necessary and sell it.
Establishing the construction budget which is to be employed for the custom house must take place after the borrower has thoroughly discussed with the loan officer and both parties are sure and clear of the implications. The starting point in the construction budget process resides in outlining a cost breakdown that accounts for all the costs generated by the build and the financing. Each component will be analyzed separately in the following paragraphs so that the reader can include them in the final formula.
The “Elements” of a Construction Budget
A. The Land
When evaluating your land, the lenders look at the period since you have owned it and usually want to see it seasoned for at least one year. If the span of your land ownership is shorter, you ought to use the land’s original price in your construction budget. If you owned it for more than the standard period, you may use your loan payoff amount. Since most of the loaners don’t allow the land loan to be a priority compared to the one of the new construction, it is usually required that the borrower pay off the land with the new loan.
The following steps will help you determine the payoff:
- verify the latest statement on your land loan and begin with the loan balance;
- add any prepayment penalties or payoff fees;
- add one month’s payment (you might have interest due at the closure of the construction loan).
B. Soft or Indirect Costs
These refer to elements which are not involved in the actual physical construction of your home and the most often encountered items listed as such include:
- Architecture fees;
- Design-review fees;
- Engineering fees;
- Permits — city and county;
- Plan check fees;
- School fees;
- Soils and geotechnical reports;
- Utility connection fees.
However, you must check the list with the lender’s guidelines because some might be considered as hard costs, depending on the policy.
C. Hard Costs (Building Materials)
They designate the expenses incurred when paying all the labor and materials used in the actual physical construction of your home. They have to reflect the overhead and the contractor’s profit and are calculated by means of the dollar-per square-foot method. However, do expect to alter them along the way.
D. Contingency
Because most of the custom house building projects exceed the initial construction budget, lenders usually settle a contingency, which represents an amount of money set aside for unexpected and unanticipated expenses. By doing so, a sort of buffer is created against cost overruns (which are most often caused by the contractors’ underbidding or the wrong estimated duration of the construction). The contingency is calculated by multiplying the hard-cost total by 5 percent, rounding this number to the nearest $500.
E. The Interest Reserve
Because banks are aware that the borrower pays to live somewhere during the build, which stretches him by multiple payments, they have introduced the requirement of the interest rate. It represents a portion of the loan set aside with the purpose of making the construction loan payments while the house is built. Although not all financial institutions demand the customers to have one, most of them do because they consider it as a way to insure that their loan is kept current.
You will not pay the interest rate on the entire loan until the very end of the build process. Use the below steps in order to roughly estimate the amount of money that you will pay as interest rate:
- Estimate the loan amount (based on the costs for the elements above, sum up the numbers and then increase the total by 10 percent; any down payment you made on the land needs to be subtracted from the result);
- Multiply the estimated loan amount by 60 percent, thus accounting for the partial use of money over the loan’s term. Banks consider that this percentage is usually used during the construction period on average;
- Multiply by interest rate, which varies from one lender to another;
- If your loan is for 12 months, the calculus is over, but, if your term is longer, divide the result from 3. by 12 and then multiply by the number of months for which the loan is granted.
F. Loan Closing Costs
This category includes expenditures generated by the lender’s and the title company’s fees (e.g. paying points, escrow, title insurance, appraisal) and insurance. These costs will vary depending on the terms and complexity of the loan, but in order to receive a rough number, consult your loan officer and insurance agent. If you don’t manage to access them, multiply the estimate loan amount by 4 percent so that you will obtain a rounded sum.
Drawing the Line and Putting It All Together
Now that the main components of a bank’s construction loan have been laid out, you are ready to sum them up and obtain a cost-to-build total. Use the example below when making your calculations.
Elements Amounts for the Construction Budget
Land Costs $125,000 (includes $50,000 down payment)
Soft costs $ 25,000
Hard costs $360,000
Contingency $18,000
Interest reserve $ 20,500
Closing costs $ 21,000
…………………………………………………
TOTAL $569,500
Once you have determined the approximate needed construction budget, you have to discuss with your loan officer and see what loan program is best to support your expenses.