UPDATE: 2013.09.09 Please see the updates in the post below. Some of the information in the previous blog post was a bit unclear, and I hope to remedy that with this update. Update in bold and marked below.
Equity. Today’s post is going to be a little bit more in the abstract than some of the others. There are a lot of facts surrounding building and the equity you have in the house at the end of the process and what can be done with it. I plan on explaining some of that today.
I was not much up on construction loans until we started down this path of building. Then, my eyes were opened to just how it all works. In order to get a construction loan, you have to already have the following:
- cost estimate from builder
- plans drawn up for builder to estimate from
- down payment of at least 15%, maybe more
Let me break those three down a little bit more, not necessarily in that order. The plans for the new house are so important. So many things depend on them, including your construction loan, as you cannot get one without them. The problem we ran into was that we were not sure if we were building too much house or not. Obviously, we needed to stay within our budget, but it is hard to know if we will be, when so many of the builders that you talk to will not give you a pretty good estimate of the costs associated. Therefore, we could not know if we were building too much house until we drew up plans, even preliminary ones, and let the builders look at those. Hopefully, from those rough plans, they will be able to quote enough of a ballpark figure that we can decide if we are building too much house or not.
The cost estimate is important for the financial institution that is issuing you the construction loan, because they have to know what they are getting into. I think some of it is in place just so that they know you are using someone reputable and with a plan. They have to protect their investment, after all. It really helps them figure out the draws they need to schedule on the construction loan when they know some of the large line items from the cost estimate.
A draw in this sense is when you draw on your construction loan. What does that mean? You are actually issued a disbursement. Well, quite a few of them. Most construction loans for home building have at least 4 draws, but can come with many more. This is so that you, or your builder, can pay for materials and the sub-contractors as you go.
Now, on to the down payment. The down payment is in place so that the institution lending you the money knows that you have some skin in the game. This keeps you from just walking away. The amount required for a down payment can differ among financial institutions, but generally, around 80% to 85% is the norm. Much of that comes from federal regulation that states they must collect the rest upfront in order to make the loan. This is really a good practice for everyone. I know, you might not think it is great that you must put money down, but it is best for society in the long run.
So, now that you have your construction loan, what happens next? Well, the work on the house begins. The builder will contract with sub-contractors for a price (usually bid in amount per square foot….such as, the trim carpenter might charge $1.50/sq ft to do all of the trim and put on all of the knobs after everyone else is done. It doesn’t sound like much, but if you multiply that times the square footage in your house plans, it can add up quickly.
After your construction loan is diminished, and all of the funds have been dispersed, the house and land will be appraised for a value. Then, it is time to secure permanent financing. Actually, you must already have someone lined up with permanent mortgage financing before the financial institution will even give you a construction loan. That way, they know that you are not going to finish this house, but not be able to fund it.
*UPDATE*
Here is where it gets interesting…when you roll this house and land value into a mortgage, it should be worth more than you paid for it. Quite a bit more, actually. To use some really rough numbers, say I spend $100,000 in expenses building this house. Say they have it appraised and it comes back as being worth $200,000. Well, in instantly have $100,000 in equity that can be applied to the new mortgage (permanent financing), just as if you were buying one new and plunked down a sizable down payment. Make sense?
This is NOT true, come to find out! In going through some more of the process with the mortgage officer, I found out that you do get this equity that I allude to in this post. However, you cannot realize the gain unless you actually sell the house. So, you do get to keep the equity that is the difference between the cost of building and the appraised value of the property, including the structure. You just don’t get to apply it as if it was a down payment. This was disappointing to find out, as I thought that we would have another $31,000 to put down on our house. It caused us to have to find land that was cheaper than we were looking at originally. Also, we had to eliminate some square footage that we had in there. I wanted to clear that up so as not to mislead anyone.
*UPDATE*
That is the whole reason it is so vitally important that you be diligent in interviewing your builders. You must build for a lower cost than the value of the finished home. You must do this, if you want to have equity and use that as your down payment in the final mortgage, that is.
What other questions do you have about this process that I didn’t cover here? Anything?