In another article, I wrote about the nuts and bolts about the process of obtaining the financing with a construction loan. What follows are the processing and underwriting requirements that a lender is looking for when you are applying for the loan. The requirements mirror those for obtaining an end loan mortgage.
- Credit: If there are any delinquencies on your credit file or if your median FICO score is less than 680, you need to get these problems addressed BEFORE you apply for a construction loan or any mortgage. Lower credit scores equal more risk to the lender and because the construction is NOT collateralized, there is nothing for the lender to obtain from you in the event of a default. Credit requirements are more rigid for construction loans. A credit score of 680 is no guarantee of obtaining a mortgage and in fact, most lenders want the borrower to have a score of at least 720.
- Income: Your income stream must show stability of employment from your employer, income that supports not only the construction loan payments, but also your current recurring monthly payments. In order for the lender to qualify you for the loan, you will need to show documentation proving the income. The documents for a W2 employee to show is 2 years W2’s and 1 month’s pay stubs. For self employed borrowers the requirement is 2 years 1040’s THAT HAVE BEEN FILED WITH THE IRS!! Un-filed tax returns are not acceptable.
- Debt to Income Ratios: The rule of thumb is the lower the debt to income ratio, the less the chances are for a default and therefore, less risk to the lender. To make sure the borrower will be more likely to make the monthly payments, the maximum debt to income ratio the lender will accept should not exceed 45%.
- Equity: To coin a phrase that my old boss used was, “LTV is GOD!” That said LTC or loan to cost is a concept unique to construction loans which also plays a part. This shows the lender how much equity you have in the property. The higher the LTV, the more risk there is to the lender. Many lenders today require a 20% to 30% equity position in the property. A construction loan with that also has less than 20% equity in the property is pretty much unheard of. If you view the loan the same way a lender does, you will quickly understand that the lender does not want most of the risk on his shoulders and a lenders portfolio is loans being paid on, not property.
- Construction loan amount and appraised values are calculated very differently from a normal purchase money or refinance loan. This type of loan needs a Future Value Appraisal and the loan amount needs a construction loan amount calculator.
- Project and Budget Approval: Be prepared to show the lender all aspects of the project from “soup to nuts”. What this means is that the lender wants to make sure that the building is up to code, has the approval from the municipality as well as the proposed draw schedule. The draw schedule should be included with the construction contract with the necessary change order provisions.
Finally, I cannot stress the importance of having all the documentation and proof ready for the lender long before breaking ground and beginning the project. The last thing a lender, or the municipality, want to see are sudden changes in the building plans, sudden drops in income or anything that could have been avoided or was under borrower control that threatens the position of the lender. Another saying that my old boss was very fond of is, “it may be your sticks and bricks, it is MY MONEY!” If the borrower cooperates with the lender, and with all things being equal, building your dream home should be a smooth process. For more information please visit: