This article is similar to a previous one, but from a different perspective.
Let's say you want to build a house on land you own or plan to buy, but before talking to a builder about financing, you do what many people would do, you call a mortgage lender and ask about applying for a loan. Makes sense. The problem is, a mortgage lender doesn't make the loan to build a house, only to buy or re-finance one. If the mortgage lender wants to gain your business, he or she needs to figure out the best, easiest, and fastest way to get the deal done. He or she knows there are 2 basic options:
- Connect you with a bank who can do a construction loan for you, or
- Have you deed the land over to a builder so the builder can get the construction loan.
Let's look at each option and the pros and cons of each:
Connect with a bank for a construction loan:
- Pros:
- You get the loan, controlling the flow of money;
- You don't have to pay a builder's profit on the interest he's going to pay to his bank;
- You maintain control of the whole process, keeping the land you own in your name, without worrying about the builder making a financial mistake that puts your land at risk.
- Cons:
- It's one more loan you have to get approved for (although with the right mortgage lender / banker combination, this is pretty simple);
- The requirements for construction loan approval are tighter than for a regular mortgage, meaning you might have to come up with more cash, and
- The ratio of your current debt to your current income must be lower for a construction loan than for a mortgage;
- You'll most likely have 2 closings (unless you can find a "one time close" option - some lenders have this, which is convenient, but usually results in a higher interest rate);
- Your mortgage lender might have to do some extra work to help you find a construction lender, and will have to coordinate a few more logistics than he or she otherwise would.
Deed your land over to the builder:
- Pros:
- Convenience. You don't have to mess with a construction loan yourself;
- One closing. You'll only need to close on your permanent loan once the house is complete, since your builder will be getting the construction loan himself;
- You save your mortgage lender the extra work of having to help you find a banker and get a construction loan.
- Cons:
- Your builder will own your land. If things go bad, you risk losing the land. If it's land that you've dreamed of owning, or land that's been in your family for years, you might not be comfortable with this situation;
- If the builder and a subcontractor get into any disagreement about payment, even if the builder is right, the subcontractor could file a lien against the property that will have to be resolved before the builder can deed the land (and new home) back to you;
- The same thing applies in the event the builder fails to make interest payments to his bank (rare, but it happens). When the builder gets the construction loan to build your home on your land, the bank will file a mortgage on the land, which ties it up until the construction loan gets paid off. You lose control of that process and have to trust the builder / banker relationship works well so you can get your land back;
If your mortgage lender suggests deeding your land over to a builder, and you decide that's the best option for you, make sure you're protected in the contract with the builder. The lender should have some good suggestions on what kind of language you should include in that contract. If you're totally comfortable with your builder, it shouldn't be a problem. If you're not comfortable with the idea of deeding your land over to the builder, you have other options available.
- Many banks have mortgage companies as well. When you get your mortgage through one of them, they'll connect you with the person in the bank who does construction loans. That removes a lot of the inconvenience associated with 2 loan applications because the mortgage person can simply pass along all your information to the banker. You'll still likely have to fill out 2 applications, but at least all the documentation you gather for the mortgage lender will just get passed along to the banker.
- Ask your builder. If you already have a relationship with a builder, or even if you're still shopping for a builder, ask them to connect you with a construction lender. The advantage to this approach is that the builder will likely recommend a banker that does lots of construction loans, and is very good at doing them. There are lots of chances for things not to go smoothly in the process of doing a construction loan, and you don't want to add to your stress by dealing with a banker that doesn't have a smooth, efficient, proven process for administering a construction loan. We've worked with many banks, and some are really good at construction lending and some aren't. We've found our clients are much happier and the process goes much faster with the right bank.
There are lots of moving parts in the whole process of having a new house built on your land. Getting a loan can be one of the most confusing and scary parts. For more information, check out some other articles I've written on the subject of construction loans and financing.