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The nuts and bolts of home construction and renovation loans

Thirteen years in the mortgage business isn’t a lifetime – but I’ve been at it long enough to see a cycle or two come and go. Right now, home construction is growing again – still only at half its 2005 peak, but moving steadily upward.

Why the increase in popularity? Developed lot parcels have been more abundant in the past two years.  We’ve also witnessed an increase in major home improvement projects that require financing.  Fortunately for borrowers, local lenders are well-positioned to help navigate the nuances of a construction loan.  Here are five things to know about construction loans.

How is a construction loan different than a typical home mortgage? Many local lenders offer “construction-perm” loans. Most homes are built in six to nine months, with larger projects taking up to a year.  Borrowers have the flexibility of paying just interest on a growing principal balance during construction followed by payments of principal and interest over a traditional time frame similar to that of a loan used for an existing home. An appraisal is still required, and is based on the home’s architectural plan and specifications, comparing it to other similar age and style homes in the vicinity.  The loan amount is based on the lower of either total costs or the appraisal.  At closing, the borrower’s down payment is deposited in escrow and those funds are used first, typically towards a land purchase or early construction costs.  Closing typically occurs within 45 days.

Are there any limits to the size of a construction loan? The average construction loan today is under $400,000 – smaller for major renovation loans (see question five below).  There is not a minimum requirement; however, loans above an industry-standard $417,000 (more on that in our jumbo loan article) can mean higher rates, more costs and more restrictive underwriting requirements.

I’m not quite ready to build but found a great lot. How does a lot loan work?  The process for financing land is similar to that of an existing home.  Expect to have a larger down payment and a shorter payback period, however, since land values are subject to greater fluctuation.  Your current home’s equity can be a vehicle to provide funding for some – or all – of the land purchase.  Closing takes about 30 days.

Do I need a larger down payment for a construction loan? By using private mortgage insurance, lending institutions like Great Midwest Bank offer some attractive low down payment options, even on jumbo loans.  This can be particularly helpful when borrowers prefer to remain in a current home during construction, that would require sufficient income to carry two mortgage payments.

What’s involved in the financing of a major renovation? Growing families are often eager to stay in a particular neighborhood but get frustrated with a short supply of larger, move-in ready homes.  Enter the major renovation loan.  Fundamentally, this is really just a construction loan.  Depending on a borrower’s existing equity position and cash available for down payment, your bank can “roll in” the amount of an existing mortgage or, more simply, offer a smaller, second mortgage specifically for construction costs.  In most cases for renovations of $100,000 or more, the former is necessary using an adjustable rate mortgage product.  At closing, as is the case with most construction loans, the original mortgage is often refinanced into a longer-term fixed rate mortgage.

More resources for understanding home lending options are at greatmidwestbank.com.

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Jon Reetz is a graduate of the UW-Madison Business School ('90) and the Kellogg School of Management at Northwestern University ('98). His 25 years of banking experience include 12 in commercial lending and the past 13 with Great Midwest Bank in Brookfield, which specializes in both owner and non-owner occupied residential mortgages.

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