3 Mistakes to Avoid with Construction Loans
Construction loans are a smart way for a borrower to quickly get funds to build a home. However, there are some things to look out for. A construction loan is a short-term loan to fund the building of a property. Construction loans are usually given to builders or home-buyers who are doing a Fix-and-Flip, building a spec home, or their dream home. While they are typically short-term loans (usually for a period of one year) other finance options are available when the house is complete. The borrower can either refinance the construction loan into a permanent mortgage or if selling, get a temporary bridge loan. Both Construction Loans and Bridge Loans normally only require interest only payments and in some cases allow for interest reserve accounts, eliminating monthly payments for the borrower.
Construction Loans are usually required to be in 1st Position (behind no other mortgages). The new loan pays off any outstanding loans and then the remainder of the funds are deposited into a Construction holdback account or is set up like a line of credit. Funds are then distributed to the General Contractor, usually on a reimbursement schedule, until the home is complete.
Something to keep in mind is the borrower’s experience comes first and foremost for obtaining a construction loan. If the borrower does not have sufficient experience, lenders will likely require the borrower to partner with an experienced Builder/General Contractor in a Joint Venture. A broker should always qualify the borrower’s experience by asking for a resume of projects completed that they own. It’s easy to include experience where a borrower was a partner in a project, but sometimes that is not sufficient and can cause headaches for all parties down the line. It is always better to be upfront with the lender about experience to avoid any potential issues with securing the loan.
Mistakes to avoid with construction loans:
Underestimating your time to complete your project is the very first mistake to avoid. Obtaining permits, changes in the project, weather, etc. Miscalculating your schedule can be the death of the project. Not only are costs added, but your interest meter is running on your construction loan. The solution (which is never perfect) is to make sure an experienced General Contractor is on the job, one who has a proven track record with budgets and time tables.
Getting a Construction loan with too short of a term. People can make the fatal error of getting too short a term on their Construction Loan to save costs. Note: projects almost always take longer than you think. We recommend that your Construction Loan be at least 12 months for Rehab/Fix-n-Flip and 18 months for Ground-Up Construction. An expiring Construction Loan is very expensive -- extension fees and potential default interest may occur. Having a longer term is less expensive than the need to extend at the end or in the middle of your project.
Forgetting to have a contingency line item in your construction budget. Contingency is used to allow for the unexpected: sudden changes in the price of lumber, cosmetic must-haves, etc. We recommend 10-15% of the total budget being allocated to Contingency. Run it by your contractor, if he says you do not need Contingency, get a new Contractor.
These are a few “never forgets” when preparing for your next construction project. Taking the steps listed above will avoid most common problems. Continue to work with proven experts for greater success with your Real Estate projects.
Paul Wirth (firstname.lastname@example.org) is the Vice President with Jcap Private Lending based in Newport Beach, CA. Jcap is a National Direct Lender offering Hard Money and Bridge Loans (including Construction Loans for Fix & Flip, Spec Residential, and Multi-Family), Commercial Loans and Stated Income 2nd’s). Jcap Private Lending is committed to solving short-term needs through Real Estate Financing.