How do mortgages work when building a house

[Chris O'brien]

Let's say I'm building a house and put down $50k, which would be well over 20% of the total costs, maybe even 30%. Do you agree on EXACTLY how much the loan would be for before the construction begins? Is there any flexibility in this if unexpected costs arise? I'm new to this and just want to be able to borrow what I need, no more or no less.

[Bryan Hancock]

That's the trouble...eh? Getting things EXACTLY correct when there are unknowns is difficult. Most builders gross the loan amount up modestly to account for uncertainty if if they're really good at budgeting. We commonly do this on our projects and let the lenders know we're doing it. Lenders generally already know this is happening and don't care as long as their security interest is not impaired. If the value of the land you place as collateral exceeds 20% LTC by a long factor they'll often advance the first part of the construction costs. If this is not the case you're likely to have to advance the first part of the construction costs and get reimbursed after they send their inspectors out to verify things are done.

Budgeting for the EXACT amount of equity required is often pretty tough and we struggle with this on all of our joint ventures. These are the factors:

1. What is your lender's peak "LTC" number? This is often quoted as 80%, but some lenders will go as high as 85% if you have high gross margins and are experienced. Some niche lenders will loan more if they also participate in the project. This number sets the ceiling in what they'll lend at any point in the project

2. What is your peak draw need? This is generally driven by the mechanicals stage in a 5-draw project

3. How many draws do you plan to do? 5 is generally a good number, but you can get away with less equity up front if you use more draws and slow the project down more. If your builder has a line of credit they can generally advance some funds to move the project along quicker too without having to break things into so many draws

4. How much money do you put up at the construction loan closing? This is generally 20% on spec houses, but I am assuming the rules are different if you're an owner-occupant or are using a one time close construction loan that rolls into a permanent loan

To figure your equity required you need to do the following:

-Figure out item 4 above
-Figure out how many draws you need per item 3 above
-From there you can figure out item 2

The rest is just an easy math problem. You add the equity required to close the construction loan and/or pre-start costs to the peak draw needed and this determines your equity required for the project.

Here is an sample for something typical in 78702 in Austin:

Land = $75k
Sticks/Bricks = $150k
Pre-Start Costs and Interest Carry = $15k
Peak Draw in 5-Stage Project = $35k

=> Equity Required = $75k + $15k + $35k = $125k

If the as-built appraisal is $350k this would mean the peak LTC would be 64%. This tells you that you have 16% margin that you can try to get as cash back out of the land or as reimbursement for some of the pre-start costs. 16% of $350k is $56k. So if you closed your land before your construction loan you'd need to find a lender that would allow you to pull cash out at the construction loan closing. If you did everything as one closing it would be easier to bring less cash.

There are also back-end ratios that matter more if you're do smaller margin projects. This is really something easier to go over with a concrete example if you can give everyone numbers. Oh...and off-budget items may need to be funded in cash so if you're bad at budgeting you many consider having an "oops fund" to nurse the project through anything you missed.

Hope this helps...Yeah....it is more complicated than it needs to be ;-)