FAQ: How does a construction loan work?

We've had a few friends and family members ask us questions about house building. The ones that come up the most are about the financial and lending part. I've compiled a list of FAQs to better explain construction loans. Because I was pretty clueless before I started this process too!

1. You haven’t closed on the house yet?

We have been paying interest-only each month on an open line of credit with the bank. As the line of credit gets larger, so does our payment. But unlike a mortgage payment, $0 is being applied to the principal. 
Construction loans are usually 6-9 months, sometimes longer depending on your lender. Our loan began May 2012 and our loan matured last month. 

2. When will you close?

We are currently in the process of closing on the home.
We have finally rounded up all the bills from each contractor. (annoying to have to ask some of the contractors for a bill several times…you’d think they’d want to get paid!) Then the appraisal is scheduled.Which is TODAY! Cross your fingers and toes for us! We are nervous.

3. Why? What is the big deal about the appraisal? 

The appraisal will tell the bank and us how much the home is worth. The bank needs to know that they are lending us at the very least what the home is worth. If we borrowed more than the home is worth, then we would be upside down on the loan. This means the loan could be a high risk loan for the bank. This is one reason we paid cash for as many items as we could while building.

4. What is the reason to put your own cash in while building a home? 

PMI, or Private Mortgage Insurance. PMI is required by lenders on all conventional (Fannie & Freddie) loans over 80% LTV (loan to value). PMI is an extra charge to the borrower on top of the principal and interest payment. If PMI is require you pay it until the loan reaches 80% LTV. It can be anywhere from a few bucks to almost $200 depending on your loan amount and the LTV. 

Why pay more money every month when there is no real benefit? I could be spending that $100-$150 bucks each month on shoes and pinterest projects! Err…I really meant put it into savings.

Let me break it down for you*:

Appraisal Value: $100,000.00
Loan Amount: $80,000.00
Loan to Value (LTV): 80% No PMI Required

Appraised Value: $96,000.00
Loan amount: $79,000.00
Loan to Value (LTV): 82% PMI required = extra fee on top of mortgage payment.

*These are just examples our loan amount and projected AV is much different

Essentially, we are hoping the large sum of cash we paid into the home--plus, the land (which we also paid cash for) will save us from PMI.

5. What else can you do to avoid PMI?

We put a heck of a lot of sweat equity into the home. Labor can be a huge charge, DIYing what you can saves big bucks!
Some of our DIY items included:

• Laying our own hardwood with the help of friends
• My dad volunteering his time, hard work, and masonry skills, to lay the stone on our beautiful 2-story fireplace and the entire exterior front. 
• We stained the staircase, newel posts, and treads ourselves
• The trim and all the doors were painted by Adam
• Friends helped us with the back patio, and the front driveway pad to save some cash
• Built our own custom walk-in closets

These items help to save us approximately $15,000 in labor costs alone! We are hoping these items help avoid the PMI monster that lurks.

6. What happens after the appraisal comes back?

Our loan to value is determined and our monthly loan payment is figured. We also have regular closing costs just like buying a home; credit report fee, appraisal charge, underwriting fees, etc. Then we close the loan with our loan officer like everyone else…only we already have the keys!

7. But why can you live in your home before you close on it?

I don’t know. We just can. Construction loans are special.