Probably the most nerve-wracking part of the Barden Home building process is working through how the payment process will go. Again, I have never built a home before, so the entire process is new to me. In fact, I think I may have come across like a complete idiot when I asked our salesman when i need to get a mortgage for the house :).
Little did I know, that you don’t get a mortgage at the outset of the construction, you get a construction loan. Construction Loans are much different than a mortgage, and rightfully so, since their term is much shorter. During construction, the loan usually requires interest only payments. The loan is usually due upon completion, which is indicated by a certificate of occupancy.
Rates are usually variable on construction loans, and interest is charged on the amount withdrawn to date. Most construction loans allow a set number of draws, like 5, throughout the construction process. These draws are scheduled based on the contractors’ needs as well as intervals the lender will allow. Again, you only pay interest on the amount withdrawn to date.
You may be wondering how much money, if any, you need to put down on the construction loan. In some cases, if you already own the land, the lender will allow you to use that as equity, therefore reducing the amount to be put down. In general, putting down roughly 15% of the cost of construction is a good policy.
What Happens After Construction? A Mortgage!
When construction is complete, and you have made all of your draws, you have a couple of choices. If you established a construction-to-permanent loan, where the construction loan turns into a mortgage, you simply get your certificate of occupancy, and begin making mortgage payments.
If you are doing two separate loans (construction and mortgage), when construction is complete, the lender that you are working with for your mortgage will want to appraise your new home to get a lendable value. Just like buying a home, it is a good idea to put down 20% of the value of the home. In this case, you will have put some money down on the house for the construction loan, so you are already part of the way there.
Before the US housing market took a dive in the past year (as of this writing), it wasn’t uncommon to build a home, and have the value of the new construction be higher than the actual cost of the home. This may be the case in some markets, but mine is probably not one of them. :). I live in a very rural area, where real estate is inexpensive (compared to the national average), and appreciation is a slower process.
If you’re lucky enough to be in that situation, you will be required to put even less down on your home. If not, and you already put down 15% of the value for your construction loan, you should only need to put down 5% of the value to make up a total of 20% of the value of the new home. It’s never a bad idea to put down more if you can, but 20% will do.
Why 80% Loan to Value is Important
So, why is it such a big deal to put down 20% or more? One word, RISK. For starters, no matter how good your credit is, the more you put down, the less risk you bring to the table for the lender, with regard to defaulting on your mortgage. Let’s face it, lenders are taking a serious look at risk/reward when handing out mortgages now. With the recent take over of Fannie Mae and Freddie Mac by the US government, and the $700 Billion bailout of the financial system that’s being proposed (as of this writing), financial institutions have to be careful with how they lend.
The more you put down, the lower your interest rate will be as well. Again, this comes back to risk. Between your credit score and history, and the amount you are putting down, you can represent more or less risk, having a direct relationship to your mortgage rate.
Private Mortgage Insurance
Lenders Mortgage Insurance (LMI) or Private Mortgage Insurance (PMI) is often avoided when you finance 80% or less of the value of the home. Mortgage insurance is insurance paid by the borrower that protects the lender against non-payment, should you default on your loan. Let me be clear. This insurance doesn’t protect you, it protects the lender. The only benefit the borrower gets is the ability to make a smaller down payment. PMI is one of the big reasons many families can afford to buy a home, with 0-5% down.
Mortgage Insurance premiums vary, but on average they are 1/2 to 1 percent of the full loan amount, depending on the size of the down payment and loan specifics. As an example, on a $200,000 loan with $10,000 down, you may pay $1000.00 per year in addition to your mortgage payments. What’s worse, is that those payments aren’t even tax deductible in some areas.
In order to end your obligation to pay PMI, in most cases you must pay to have an appraisal done, and the outcome must show that your loan to value is under 80%. This can be done by additions that increase the value of your home, rising market values, or simply paying down the loan.
Who Doesn’t Want a Lower Payment?
Although financial advisors will always tell you that if your mortgage rate is less than 10% (which it sure as heck better be!), you’re better off putting as little down as possible and investing the rest of your savings, I think there’s more to this decision than simple math. You need to take into consideration your current income level, the potential for that to decrease/increase (most importantly decrease), and your actual ability to save the money not being put down on the mortgage.
If you are self-employed, and the odds of you seeing a soft spot in your business cycle are great, I would recommend putting more money down and lowering your monthly obligation. If you think the extra savings will burn a hole in your pocket, put it to good use, and spend it on your home.
A very intelligent business man once told me, in business, you need to live off the valleys and save the peaks. Make sure you get your monthly payment at a level where the financial valley’s in life can cover it.
Fixed Rate or Adjustable Rate Mortgages
Regardless of the loan to value you end up with, you’ll have the choice between a fixed rate or adjustable rate (ARM) mortgage. Much like the name implies, your mortgage interest rate will either be the same for the term of your mortgage, or it will adjust over time. You might be thinking to yourself, why the heck would it change over time? Well, there’s a benefit to committing to an adjustable rate mortgage. The interest rate for a short period, is fixed at a rate lower than the average fixed rate mortgages. For example, if the current fixed rates for a 30 year mortgage are 6.25%,the short term fixed rate on an ARM maybe 6.0%. After the fixed period, the rate can increase or decrease depending on the current Fed rates and other factors. So, after the term for the lower rate ends, you may find yourself paying a much higher rate.
This is exactly what happened to the 1000s of people that are foreclosing on their homes. The rates have gone up so much, that the borrower can no longer afford the payments. During a time like we’ve had over the past 5+ years, it seems silly to go with anything besides a fixed rate mortgage because rates are very low right now.
If you think you can handle an ARM and your ability to refinance into a fixed rate after your short term rate is up is high, then by all means, give it a whirl. Just be cautious of any rules stipulating charges for early payment.
More to Come
My wife an I are currently in the process of getting pre-approval for our construction loan, so I will post some updates as we go through that process.