Custom-home buyers require special loan, mortgage products

     By Jim DeBoth
     Mortgage Market Information Services
      The popularity of buying a lot or parcel of land and building a custom home has risen sharply. To do this, custom-home buyers need to obtain a construction loan, which puts them in a whole new and puzzling world.
      The process for obtaining construction financing is quite different from the process of obtaining a regular home mortgage. The first, and sometimes most difficult part for the borrower to understand, is how the construction lender determines the value of the project. A common misconception is that one only needs a site and the home plans to obtain a loan to build the house. It's not quite that simple.
      Some construction lenders will use the completed value of the home as a yardstick to determine the feasibility of the proposed project, but most will establish the "acquisition value." This consists of the cost of the land, plus the carefully documented actual cost of construction and all permits required, and a contingency allowance, usually 20 percent of the costs. The loan will then be limited to a percentage of this figure, often 75 percent. Here's how such a loan would look: The lot/land cost is $50,000, the construction cost is $80,000, and the contingency cost is $16,000 (20 percent of $80,000). This makes a total cost of $146,000, with a maximum loan value of $109,500 (75 percent of $146,000).
      The project is eligible for a loan of $109,500, but only $96,000 is required to build it (cost plus contingency).
      There is one more item to consider -- an interest reserve fund. Interest on construction loans is charged each month on the amount disbursed for the project up to that month. To simplify the process of servicing these loans, many construction lenders add enough to the loan so that the accrued interest each month can simply be charged against the funds still available in the loan commitment. In our example, this yields an amount of $5,500.
      When we add this to our cost total, we arrive at a final loan amount of $104,500, still well within our maximum loan limit of $109,500. At this point, our project summary looks like the following:
      We have an overall cost of $146,000, a loan of $104,500, and the equity required is $41,500. This means the homeowner would need to own the lot free and clear to build this house at the illustrated cost with the loan program. The lender always wants to see the owner's equity on the line when financing new construction, but sometimes it is not necessary for the land to be free and clear because of variations to this approach.
      In these situations the future value of the home becomes important. Let's say that, given the location of our project, the completed home will appraise for $190,000. In the event additional funds are needed to complete the land purchase, many construction lenders will include an advance of as much as 50 percent of the purchase price of the building site, with the borrower putting up the other 50 percent.
      Again, there are limitations to the loan amount, but in this case the lender now relies on the future value of the home. The loan limit for the advance for land purchase and the total cost of construction, together with the interest reserve, will usually be limited to 80 percent of future value. Some lenders, especially if the borrower has a commitment for the mortgage, will loan as much as 85 percent of future value.
      Using our example of a home that costs $146,000 to build, and upon completion will be worth $190,000, an 80 percent loan limit would allow $152,000 in financing. This leaves plenty to add $25,000 to the construction loan of $104,500 to advance half the $50,000 cost of the land. Thus, the prospective builder now needs only $25,000 toward the cost of the lot.
      The terms of construction loans also vary, however, most are for one year. Even though most homes, even custom ones, can be completed in far less than a year, the interest reserve built into the loan will carry it, giving the owner/builder ample time to shop for the best mortgage terms and to generally tidy up and add finishing touches. Loans are also obtainable for six- and nine-month periods.
      Having chosen a finance program, the owner/builder then has to deal with documentation requirements besides those needed for the eventual mortgage, which will pay off the construction loan. In addition to an appraisal made from the borrower's home plans, the lender will require a detailed cost breakdown listing everything that will be done to build the home. The lender will also need a complete description of the materials to be used. The lender will supply these forms for completion by the owner or his contractor.
      Another concern is whether the homeowner should act as his own contractor or hire one. It's tempting to try to do the contractor's job, but without experince in home building, it is generally better to hire a professional.
      --Jim De Both is president of Mortgage Market Information Services -- a national publisher of mortgage rates and information.