Applying for a construction loan that would help you carry out your plans of building a custom house requires careful preparations in advance. You don’t just get the required papers and stack them into a file that is to be handed down to the lender. You have to make sure that its content is as favorably presented as possible.
In other words, it is all about how to please a lender. Therefore, if you want to succeed in getting qualified and receiving funds for the custom house project, do some research ahead and consult specialists regarding the general requirements and guidelines of a construction loan. Thus, you may “mold” your information to better match the standard profile.
Criteria for Validity and Lucrativeness
Once a lender is asked to grant a construction loan, he will automatically establish a set of expectations from the borrower that are related to the latter’s:
- Property – the more marketable and likely to be sold your house is, the safer the construction loan looks to the lender; banks appreciate valuable but conformist, well-positioned houses that feature the broadest possible interest to potential buyers; thus, the chances to sell the property fast for the highest price in the worst of economic markets become more promising;
- Contractors – the lending bank usually wants to see that the contractor in charge with the house building has solid experience and expertise in this area and is, therefore, capable of finishing it; the contractor’s license and insurance (liability, workers’ compensation, and so forth) are other points of interest for the lender, who expects these to be in order;
- Occupancy – depending on who is going to live in the new home, the bank can estimate what its liabilities are;
- If the borrower is the future resident, the house is then considered owner occupied, which is a type of occupancy that gets the best rates and most flexible underwriting terms. In this case, the lender considers that there is little risk for the occupants to leave their primary residence and, consequently, default the construction loan;
- If the borrower intends to use the custom residence only as a vacation house, the situation is referred to as second home occupancy; in this case, the lender will condition the construction loan with slightly less favorable terms, checking whether the home is located in a likely vacation area or resort town and not next door or across town.
- Whether you plan to rent or even sell the new house as soon as you finished it, the lender considers it as a speculative (spec) or nonowner-occupied home and, consequently, is less prone to offer you a construction loan because of the added risk of default.
More on Occupancy
Since occupancy is a rather tricky aspect, the article will continue dealing with it in the following lines. If you, as a borrower, don’t know exactly what to do with the new home after its completion, you are recommended to choose the owner-occupied regime and postpone the decision to sell it. Thus, you enjoy the best construction loan programs. In order to meet their requirements, you have to move in within 30 days of the build’s end.
However, the best part is that few construction loan agreements stipulate what exactly occupancy implies or how long it must take. But keep in mind that it would look suspicious if you listed the residence for sale before the construction loan has been converted to permanent financing. Moreover, if the lender suspects that the property is destined for speculation, the construction loan may be turned down or the borrower incurs a prepayment penalty (a fee charged if you sell the house or refinance it within a specified period, usually three years). Putting the house on the market although it isn’t finished or defaulting the construction loan after you have stated owner occupancy is likely to end up really unpleasantly. Under these circumstances, the lender is entitled to require the note to be paid off in full immediately and sue you for fraud, depending upon state laws.
Having What It Takes for a Spec Construction Loan
Now that you are aware of the risks to which you are exposed if trying to “trick” a lender, you can plan your construction loan application file more carefully. If you are determined to build a custom house with the purpose of selling it after it’s finished, then you will need spec financing, which might come in two forms- well-qualified and unqualified. Since this form of financing is out of the scope of a construction loan, let us tackle with it separately.
In order to confidently walk into a bank and obtain a spec loan, you need to meet the following conditions:
- have an excellent credit;
- boast an income that is three times the amount of their monthly expenses;
- provide a track record of building and selling houses successfully;
- possess liquid assets equal to approximately one third of the amount they are intending to borrow.
A Lender’s Overall Expectations – Giving Him What He Wants
When putting together the paperwork necessary for a construction loan qualification, you need to do your best in order to make your “package” look as attractive as possible. Remember that underwriters look for “flaws” to turn the construction loan down and scrutinize certain sections more carefully. The preliminary stage includes assessing whether:
- the borrower has a credit score of 620 or above;
- the property is “off the grid” (not connected to a conventional electricity utility);
- the loan-to-value ratio is 80 percent or below.
If these features are fulfilled, then the underwriters analyze the file against a set of guidelines that require:
- to have some previous experience in custom house building;
- the borrower’s debt-to-income ratio to be less than 42 percent;
- to have an average bank balance of at least $5,000.
Try to build a file that fits the lender’s guidelines from the start because you cannot go back and resubmit the application. As stated earlier, the underwriting system that sorts construction loan applicants lays emphasis on certain aspects. Let us inspect them.
I. The Credit Score for a Construction Loan
Credit scoring is one of the most important factors taken into consideration by an underwriter when assessing a borrower’s file. In the United States, there are three major companies that provide reports on people’s credit, namely Experian, Equifax and TransUnion. In delivering their reports, these bureaus use a computer modelling system to analyze data and predict how one will perform on one’s construction loan.
Once you are attributed a credit score by each of the three ventures, the underwriter examines both yours and your spouse’s. Then, the middle score of the three is calculated for each of the two, the lower being used in the assessment. There are four main categories in which a person can be included depending on her credit score:
- excellent (+720) – it enables one to be qualified for just about any loan program;
- good (680-719) – it guarantees approval in most of the lending programs;
- fair (620-679) – it limits the borrower’s options to a certain type of programs; scores higher than 680 or 640 are required in the majority of no-income-qualifier and full documentation programs, respectively;
- subprime (619 0r less) – also called as the B-paper category, this credit score is considered as insufficient for loans by almost any institutional lenders.
These values are influenced and depend on the following issues:
- Derogatory (bad) credit – a problem like this can be created by instances such as late mortgage payments within the last 12 months, late payments on car or student loans, recent collection accounts, tax liens, bankruptcies, and foreclosures; but before starting to pay these debts just so you can solve the problem of a bad credit, consult with your loan officer, because a decision like this might worsen the matter, making your credit score drop even more;
- Credit card balances – using a credit has the best outcomes for individuals who know how to use it wisely, keeping their credit card balances in order and under control; so that you don’t encounter problems when applying for a construction loan, you need to have enough credit available and balances that would equal about 35 percent of the available credit limits;
- Inquiries – every time you borrow money from a financial institution, the prospective lender checks the state of your credit, asking for a report; the number of these inquiries greatly influences your credit score- the more you have, the more you look like a troublesome customer. Therefore, you should try to minimize the instances when such a report might be asked or provide the information yourself, after checking your credit status.
These having been said, take your time and talk to your loan officer in order to identify ways to improve your credit score.
II. Tax Returns
Another key element at which lenders look when analyzing your application file is your income. It becomes less important if you have a good credit and the proposed construction loan amount is a low percentage of the property value. In the case of some programs, income is not even taken into consideration. However, most of them require certain standards to be met in this respect. So here are the main categories into which customers fall when their gross monthly income is calculated and the basic features corresponding to each class that underwriters analyze:
- salaried – interest will be shown towards the last two years’ W-2s, tax returns and most recent pay stubs; lenders want to see stable employment and a justified value of the current salary;
- commissioned – the persons who have a variable income have to present their most recent tax returns from the last two years; after averaging the income and deducting business expenses listed on the tax returns from it, the lenders expect to see a consistent or increasing income;
- self-employed – the ones who own at least 25 percent of a company are considered to be self-employed; when borrowing money in this capacity, they have to present their two years’ personal and business tax returns, as well as a year-to-date profit and loss statement (YTD P&L). The lender adds these totals together, divides the sum by 24 plus the months covered in the P&L and then sums it with the personal income;
- other income – in this case, lenders examine any other income or losses that one obtains from rental properties, investments, partnerships, and other sources. The income is adjusted by the profits or losses, using two years’ averages.
Irrespective of the income category you belong to, lenders want to be sure that your earnings are enough to make timely payments for your new home, as well as any other payments you have to make, such as for cars and student loans.
III. Bank Accounts
It goes without saying that the lender expects the borrower to have as much available cash as possible in his bank account. Thus, the former knows that the construction project is protected. Loan underwriting is usually focused on the areas of concern listed below:
- cash in the project – after accounting for any money needed in the project, the lender calculates all other cash requirements as well; the borrower has to deposit this money in escrow before the bank funds the construction loan;
- cash-reserve requirements – certain programs require cash reserves, which represent funds that have been left in savings or investment after you deposited all the required funds into the project; the requirements in this respect vary according to the loan program, the amount of necessary money being calculated on multiples of the PITI (principal, interest, taxes, and insurance); however, most lenders want to discover anything from 2 to 24 months PITI verified as reserves.
- money to support income – this principle refers to the fact that lenders expect the cash one has in the bank to reflect one’s earnings, especially when you don’t provide income documentation.
As useful advice in this area of interest, the borrower should first estimate the specific amount of money necessary to qualify before applying for construction loans and avoid supplying his account in a sudden manner or in a short period of time. When verifying your liquid assets, a bank wants to see that the money has been there for a period of time and not recently borrowed to “pump” up your account.
IV. Appraisals
Since an appraisal evaluates the marketable value of a house, it should be as good as possible because lenders see in this a good opportunity to cover their back in case you default the construction loan. The task of assessing a custom house is challenging because the object of evaluation is not built yet and its real value is given by what someone is willing to pay for it.
By means of a physical inspection and the plans that you provide, the appraiser conceives a regulated form which describes every detail of your property, establishing a probable value based upon comparable properties that have sold in the area within the not-too-distant past. Among the items included in an appraisal are the cost for the build and a description of the materials to be used in the construction.
After collecting data on your future custom house, the appraiser has to find comparable properties, that is properties similar to yours in terms of size and location which have been sold within the last six months. The value of your home will be then determined based upon the way in which its features are better or worse than the ones of the properties used as comparison standards.
This part of the construction loan applying process is the most subjective one, often requiring some luck too. You are advised not to pressure the appraiser to increase your property’s value because the lender might feel it is overstretched and downsize the construction loan amount. You should let the appraisal be more conservative as long as you know that the value is sufficient to support your construction loan.
Now that you know a lender’s main points of interest, start planning and consulting with your construction loan officer so that you maximize your “portfolio” and enhance your chances of obtaining the cash you need to bring your custom house to life.