Builders can lower construction financing costs by using alternatives such as construction-to-permanent-loan programs and revolving lines of credit.
Combined Construction and Permanent Loan Programs
One financing tool builders should have in their kits is the combined construction/permanent loan, which allows builders to partner with home buyers and benefits both parties. The combination construction/permanent loan, which is also known as a "one-time close, a “single close,” or an "all-in-one" loan, is made to the home buyer instead of the builder. This financing technique has long been used for higher-end custom homes where the home buyer already owns the lot, but now is being used in small and mid-size tract developments as well. In these cases, the construction phase of the loan finances acquiring the finished lot and constructing the home.
Advantages for Home Builders and Buyers
Construction/permanent loans offer several advantages to builders and home buyers. These loans save both the builder and the buyer time and money, because the single loan closing eliminates multiple loan applications, approvals, fees and closing costs. Because the home buyer takes out the construction loan, the buyer pays the closing costs and interest instead of the builder. Home buyers benefit from being able to lock in the rate on the permanent mortgage when construction starts, and they are generally allowed to shift to lower rates, if available, prior to completion of the home. Another benefit to home buyers is the ability to deduct the interest on the loan during the construction phase. Moreover, since they are paying both the closing costs and the interest, these loans offer buyers some valuable bargaining points for obtaining a lower sales price.
For home builders, other advantages include guaranteed sales contracts and avoiding lenders' loans-to-one borrower limits. Indeed, this financing arrangement stays off the builder's balance sheet and keeps the builder's lines of credit available for other projects. Home builders who have experience with construction/permanent loans find that because their customers are the borrowers in these transactions, the customers are more committed to the home purchase than home buyers who use more traditional purchase loans.
Further, the assurance of the permanent mortgage loan helps to overcome some lenders' reluctance to make small residential construction loans that carry substantial overhead costs. Additionally, since bank/thrift regulators view the loan as a consumer mortgage loan, the maximum loan-to-value ratio during the construction phase is governed by regulations on permanent mortgages rather than the more stringent rules for builder construction loans.
From the builder’s perspective, a downside to these loans is that participating builders are subject to lenders' performance reviews. Some programs may also give buyers more control during construction than standard pre-sale contracts. Nevertheless, since these loans can offer substantial time and cost savings, builders should ask their construction lenders about construction/permanent loan options.
How Construction/Permanent Financing Works
The loan starts out as a construction loan (or acquisition/construction loan) and then rolls over into a permanent mortgage when the house is completed. Terms of construction/permanent loans vary, but generally during the construction phase home buyers pay interest as a spread over prime, and the construction loan runs anywhere from 6 to 12 months. During construction, the home builder receives periodic payment or “draws” from the lender. These draws usually require an inspection by the lender or lender’s representative and follow a schedule that is outlined when the loan closes.
When construction is complete, the outstanding amount of the loan converts to a permanent mortgage, either fixed- or adjustable-rate, with a term of up to 30 years. The rate and other terms of the permanent mortgage are set up-front when the entire loan package is closed. Loan amounts range from $100,000 to more than $1 million, with downpayment requirements established by each lender. Combined construction/permanent loans are offered by several types of lenders, including banks, thrifts and mortgage companies.
Revolving Line of Credit Construction Loan
A revolving line of credit construction loan (also referred to as a revolving loan) can minimize how often the builder incurs negotiable and non-negotiable loan fees and thus reduce a builder’s total financing cost. A line of credit provides the builder with financing for several homes at a time, so the builder doesn’t have to take out individual construction loans for each home built. The line of credit may specify the maximum dollar amount of the construction loans, the total number of loans, the duration of specific loans and the number of speculative homes and models that can be built under the line. Lenders often prefer to provide a line of credit for pre-sold homes rather than for speculative building. The interest rate on revolving loans is usually tied to prime, but the margin is typically lower than that on individual loans because of the larger loan size of revolving loans. For example, the rate on a revolving loan might range from prime plus one-half percentage point to prime plus 1¼ percentage points, compared to prime plus one or two percentage points on a smaller individual construction loan.
Additionally, a revolving line of credit offers builders significant cost savings because there are fewer transactions and other recurring costs associated with several individual loans. When a builder obtains an individual construction loan for each home constructed, all of the associated costs are applied to each loan. Thus, a builder who constructs 10 homes a year and takes out a $100,000 construction loan for each home will borrow $1 million over the year, but will pay the same inspection costs, document preparation charges, recording fees, title insurance premiums, etc., on each loan. Instead, if the builder constructs the same number of homes under a $1 million revolving loan, their marginal costs will be reduced due to fewer transactions costs, such as for recording fees, incremental title insurance premiums, etc.
Some costs such as inspection fees may not be avoided or reduced by using a revolving loan, but others may be saved on an aggregate basis. For example, in some states, title insurance premiums are highest for the first $100,000 insured and then are gradually reduced as the amount of coverage increases. Thus, a builder could reduce title insurance premiums by using a revolving loan rather than several individual loans.
The builder can realize even more significant cost savings by using the revolving nature of the loan to borrow more than its face value. This essentially reduces the loan fees because they are spread over a greater number of homes. Returning to the original example, using individual $100,000 loans with a loan fee of 1%, the builder would incur loan fees of $10,000 to build 10 homes. If, however, the builder uses a $1 million revolving loan with the same 1% loan fee, the average loan fee per house drops as the number of homes built increases beyond 10. In the example, the aggregate loan fee would fall to an average of $909.09 per house for 11 homes built, to $833.33 per house for 12 homes, to $769.23 per house for 13 homes, and so on.
A key advantage of revolving loans is the assurance of financing, which allows the builder to better schedule construction workflow. The builder has the ability to “turn” the loan -- to draw, build, sell, pay down, and draw again. In the above example, under the $1 million line of credit, the basic loan documentation could be done one time at the beginning of the year and much simpler documentation could be used during the year to initiate funding for each home.
Revolving loans for construction do have some complexities related to title insurance, documentary excise taxes, intangible taxes and other considerations specific to the lender’s and builder’s local jurisdiction. Typically, lenders offering revolving loans for construction will work out administrative methods for dealing with these issues. Revolving loans can offer significant savings for builders who are able to build, sell and close efficiently, and builders should consult their lender about the possibility of using them.