Construction Loans 101
A Primer for Homeowners Looking to Build/Re-build in the Wake of Hurricane Helene
We at Marshall, Roth & Gregory, P.C. hope that you are all coping
with the aftermath of the Hurricane Helene disaster in as successful and
stress-free a manner as possible. To assist in that, we are
providing this article on construction loans for rebuilding or repairing
damaged properties.
What is a Construction Loan?
In
general, a construction loan is a regular mortgage loan secured by real
property with the intent to use the loan funds to pay for
construction. Construction loans can also be used to fund a
property purchase with construction activity to follow. Be aware
that there may be limitations on using traditional construction loans
for repairs as opposed to new building activity.
The lender advances the loan funds through a series of draws over the
course of the construction process. During the construction period, the
borrower pays only interest accrued and not any reductions to
principal. For example, if the lender advances $25,000 at the
first draw, then one month later the borrower must pay the bank one
month’s worth of interest on that amount. If the second draw is
$50,000, then the next payment will be one month’s interest on $75,000 –
the total of all draws to that point.
Managing Draws
It
is important for a borrower to understand the draw process in order to
avoid cash flow challenges. Lenders will typically advance funds
only for construction completed according to the draw schedule in the
loan documents. For example, one draw might be for all of the
framing work, which will have a percentage of total cost assigned to
it. At the conclusion of that work, the builder will request a
draw, the lender will send an inspector to the site to verify the work
is completed satisfactorily, and the borrower will approve the
draw. This process is often handled through an online portal.
The
problem is freeing money to purchase materials. In this example,
the builder will need to buy all of the lumber to complete the framing
work, and the lender will not advance funds until the framing is
complete. That leaves the borrower or builder having to fund
the purchase of the materials, and many builders understandably are not
willing to advance their own money for this purpose. A borrower
needs to be aware of this process and plan carefully with the lender and
builder to make sure all funds are available when needed in light of
the personal funds to be invested by the borrower. Some lenders
will advance 50% of material costs for the next phase of
construction. A further complication can arise if the lender
requires the borrower to deposit the borrower’s contribution to
construction costs with the lender for use in the draws. Many
lenders require this, and if it happens, then the borrower has no
control over their own funds to advance money for materials or pay
shortfalls to the contractor.
A
borrower also needs to manage the number of draws requested. Most
loans will price in an expected number of draws, and if the borrower
requests more than the allotted amount, the lender will add a charge for
each extra draw requested and processed.
Lien Waivers
Another
part of managing some construction loans is obtaining interim lien
waivers. These are documents in which any contractors receiving
payment from the lender’s release of a draw state that, with receipt of
that payment, they are paid in full to that date and have no right to
file a lien upon receipt of that payment. This can be contentious
with some contractors and subcontractors and will require careful
planning. An attorney can provide the appropriate interim lien
waiver form.
Loan Takeout or Conversion
The
final thing to plan for in a construction loan is the form of loan
takeout or conversion. Historically, at the end of the
construction period, the borrower would refinance the property, now with
a new house on it, into a permanent 30-year mortgage with a complete
second closing. More recently, lenders have offered new loan
products called “construction-to-permanent loans.” In these loans,
at the end of construction, the loan automatically converts to a
regular mortgage without the necessity of a whole new closing.
There is some required paperwork to document the payment of all
contractors, the release of all lien rights, and an update to the title
work on the property to make sure there are no new liens or impairments
against the title at the time of conversion.
Conclusion
There
are a lot of variables in construction loans that require careful
planning to coordinate. Early discussions with the lender and
contractor are necessary to ensure a smooth construction process.
MRG will be happy to assist you throughout the lifecycle of your project..
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