“By failing to prepare, you are preparing to fail.”—Benjamin Franklin
There are many aspects of life to which this saying applies, but few as much as the purchase of a home and even more so a major renovation. Without a concrete plan of financing your construction you may have to stop construction in the middle of the process.
Securing financing for construction could prove much more difficult than a typical mortgage. Most banks don’t offer construction financing because it’s a line of business they don’t wish to be in, and the ones who do charge a premium. Furthermore, issues could arise if you don’t properly plan for the costs relating to the construction. Total costs often exceed your expected costs and the timing is often longer than you expect.
While your bank is probably the best rate available for a purchase or even a refinance, it may not be a possible source for the funds you needed for construction. So you likely went elsewhere for your construction needs.
The good news is, once your construction is finished you can call your bank because they’ll be happy to refinance the loan of a completed home. If the terms you now have on your finished project are not competitive or if you financed it yourself, it likely would be prudent to explore the possibility of a refinance.
If you don’t know where you are going, you’ll end up someplace else. (—Yogi Berra)
Refinancing a construction loan has certain components that are important to consider.
- If you secured the loan from a commercial bank, the term is likely to have a defined expiration date. Be sure you comply with that expiration date. I had a situation where the construction took longer than expected and the borrower ended up defaulting on his construction loan because the loan term was not extended and the construction was not completed. Because the construction loan was not extended the borrower could not make a monthly payment to avoid default, and because the work wasn’t completed he wasn’t able to secure a new loan to pay off the construction loan. (It all worked out in the end but there were a few anxious weeks.) Timing of the new loan and the expiration of the old loan can be very important. Defaulting on the old loan may limit the ability to obtain a new loan.
- If you have a construction-to-permanent loan (the construction loan becomes a regular mortgage), chances are the new rate and term are not the most competitive. While it’s a useful product to have—because this way you know you have a permanent loan when the construction is done—it may not be the term you wish or the best rate. Fortunately, you have the flexibility to now look for a new loan that may be more competitive once the construction is completed.
- If you financed the construction yourself and wish to now take out a new mortgage to pay yourself back, you should be aware of several points. Since you’re not refinancing an existing mortgage, this will likely be considered a cash-out rather than a rate and term mortgage. A cash-out could have a higher rate and more limitations. Based on your particular situation you may want to explore your options. Check with your bank to confirm what the limitations of the cash-out are and be aware you may not be able to obtain more than that in a refinance. For example, if you currently have a million-dollar mortgage and you spend two million on your renovation, the amount you can obtain on your refinance would be limited to the lesser of whatever the loan to value (ltv) limit the bank has and the cash-out limit. If the appraisal is 2 million and the maximum loan is 70 percent ltv but the cash-out limit is 500,000, the maximum loan will be 1.4 million even though the cash-out limit is 500,000 because the total loan can’t exceed 70 percent ltv, or 1.4 million. The borrower will only obtain an additional 400,000 plus the initial mortgage of one million. Cash-out limits could go as high as 1.5 million at Citibank in certain situations. Other banks will have their own limitations. If the appraisal is 3 million and the ltv limit (70 percent) is 2.1 million, the cash-out limit could limit the loan, in this example to 1.5 million, since the cash-out limitation is 500,000.
- Finally, one issue that most borrowers don’t consider is the idea that the appraisal can come in at less than they spent on the construction. Just because you put money into the home doesn’t mean the appraiser will give it the value. If your home is the nicest in the neighborhood, and there are no recent local comparable sales to your beautiful home, the appraisal is likely to come in low. Unfortunately, the bank will limit the loan amount based on the appraisal and not what you think the house is worth.
Give me six hours to chop down a tree and I’ll spend the first four sharpening the ax. (—Abraham Lincoln)
As is the case with any of these articles you read providing advice, it’s meant to give you an awareness of the issues, not to make you an expert. Fortunately, loan officers don’t charge by the hour so it’s in your best interest to reach out to someone you trust to pick their brain when you’re starting in the decision process rather than when it’s too late.
A stitch in time saves nine (—Francis Bailey, English Proverb) and an ounce of prevention is worth a pound of cure (—Benjamin Franklin) all certainly apply in the mortgage business, as does “planning today will save a bunch of cleanup when you want to close” (—Siegel).
In preparing and addressing your needs and objectives, if you start at an early stage, you will make the process much easier. Don’t wait for the construction to be finished. Make the call as soon as possible. Because the most relevant rule that applies in the mortgage business is Murphy’s law, if something can go wrong, it will (—Murphy).
By David Siegel
David Siegel is a home lending officer for Citibank working out of the Englewood and Clifton offices. Contact David to learn about the pricing and programs available for Citibank customers and to discuss financing options. He can be reached at [email protected]. nmls # 277243
