New Construction Home Sales Are Soaring, but Financing a Purchase Can Be Tricky

This year, new home sales have surged to levels not seen since before the Great Recession. Pressured by the exceedingly low inventory, shoppers have flocked to new construction, buoying builders’ confidence to record highs in an industry that has been slow to emerge from the last economic downturn.

In August, new single-family home sales tracked a seasonally adjusted annual rate of more than 1 million, a threshold last crossed in 2006, according to the Census Bureau. This figure marks a whopping 43% growth year-over-year. More than one third of the new residences sold in August were still under construction. Another third were not even started yet. In September, permits issued for new single-family builds rose more than 24% from a year earlier.

“Builders are gearing up for an even faster pace in the months ahead, which is welcome news for households wanting to buy a new home,” said Mike Fratantoni, chief economist for the Mortgage Bankers Association.

The appeal of new homes is hard to ignore in a pandemic that has recalibrated home shoppers’ preferences and lifestyles. New builds are often bigger, allowing families stranded at home due to the virus to more comfortably work, live and learn together. Never before occupied, they also carry a perception of cleanliness in a society now fixated on health and hygiene.

To buy or build new homes, however, purchasers rely on home loans that differ from conventional mortgages and that can be confusing for the unfamiliar.

What types of loans are available for new homes?

There are two primary kinds of new-construction homes — homes built enmass in residential subdivisions and custom houses erected to homeowners’ specifications — that dictate what kind of loan a shopper needs.

If you are buying in a large-scale development, which is where most new houses in the nation are located, you’ll typically need what is called a new-construction mortgage. In order to claim a home, a homebuyer applies for a mortgage early — sometimes before construction even begins — presenting the builder with a proof of a loan pre-approval. The loan is only closed once the residence is finished.

Most builders have preferred lenders, who are familiar with their projects, but buyers are not required to work with them. Knowing the builders’ timelines and home values, those preferred lenders offer convenience for buyers, although they do not always have the most competitive rates. Thus, purchasers should shop around for new-home mortgages, which many big lenders offer. To qualify for a mortgage on a newly built home, most borrowers have to meet the standard requirements associated with the general type of a loan they seek such as an FHA loan or a conventional one.

Construction loans, on the other hand, are meant for custom homes, where the homeowner works with a builder and a lender to purchase a plot and erect a house. During the building process, which can take up to a year or more, the homeowner carries this type of loan. Once the residence is finished, the construction loan is converted into a mortgage.

Unlike mortgages that pay out a lump sum so that the borrower can execute the purchase of an existing residence, construction loans are made of draws or disbursements of funds for each stage of building. In most instances, the builder — and not the borrower — receives money directly from the lender when it is time to, say, lay the foundation, complete the roof or install plumbing. During the so-called draw period, the borrower is only required to make interest payments and only on the money already released.

“It works like a line of credit,” explained Chace Gundlach, who oversees sales and home lending at Citizens Bank. “The payments are smaller in the beginning. And they'll gradually increase as we advance more funds.”

How to qualify for a construction loan

“There's a limited number of lenders that do custom construction, because it is a niche product,” said Fred Bolstad, who leads retail lending for U.S. Bank.

From the lender’s perspective, a construction loan is riskier than a mortgage because there is no collateral — no actual home — to secure it. Because of that, lenders impose stringent qualification requirements. To sign off on a construction loan, most banks ask for a credit score of at least 680 — at least 50 points higher than what is typically needed for a conventional mortgage. Construction lenders also seek low debt-to-income ratio and cushier cash reserves.

For example, Citizens Bank customers may require a borrower to maintain a stash of cash large enough to cover the interest on their construction loan for up to a year. While borrowers pay off only interest during the building phase, the rate on a construction loan can be up to a whole percentage point higher than that on a mortgage. (Currently, the average rate of a 30-year fixed-rate mortgage is 2.81%. Depending on the lender, the rate on a construction loan can be close to 4%.)

“Because it's interest only, the rate is a little bit higher, but the payment is very low because you're not paying principal,” said Bolstad.

Along with paying higher interest rates, construction-loan borrowers have larger down payment requirements, amounting to at least 10% of the home’s estimated value. (You can get a standard mortgage with as little as 3% down and the average is around 6%.) To appraise homes that are yet to materialize, lenders rely on builders’ construction plans — including cost breakdowns and specifications of home features — and any recent sales of comparable existing homes nearby.

In order to approve a construction loan, some lenders may also want to vet the builder, much like they evaluate the borrower. Lenders mainly verify the company’s licensure and creditworthiness. Other banks like Citizens and US Bank might only check the builder’s industry reputation and past work.

Transitioning to a mortgage

Construction loans can either be one-close (construction-to-permanent loans)or two-close (construction-only loans). The main difference between the two is how the short-term construction loan becomes a long-term mortgage.

With a one-close construction loan, the borrower commits to a mortgage upfront, agreeing to a bundle the two financial products. They go through a single application and approval process before construction begins. Once the home is ready, the construction loan rolls into a mortgage with a principal amount equivalent to the cost of building. Both U.S. Bank and Citizens Bank only offer this type of construction loan. “It's the simplest, easiest way to do it,” said Bolstad.

However, because the borrower agrees to a particular mortgage rate in advance, at the time of conversion, interest rates may have dropped. In that situation, homeowners can immediately apply to refinance their new mortgage in order to take advantage of the lower rates.

With a two-close construction loan, borrowers apply for a construction-loan and, later, for a mortgage. By applying for the two independently, borrowers can shop around for a mortgage or repay their construction debt through other means, such as the proceeds from an existing home sale. But, two-close loans can also mean that homeowners will have to qualify twice — first for the construction loan and afterwards for the mortgage — and pay twice the usual loan fees.

Regardless of the type of a construction loan, closing costs can range from 2% to 5% of the home’s value. Not much different from the closing costs on a stand-alone mortgage, they include fees for credit checks and other loan underwriting procedures, title insurance and transfer and recording fees, among others. Depending on the homeowner’s contract with the builder, the latter may offer some modest assistance with paying the closing costs.

Complications

Home construction seldom sticks to a schedule. Recognizing that finicky nature, a lot of lenders offer a cushion for overdue work. Citizens Bank, for instance, provides a 30-day extension. After that, it levies a quarter-point fee for every 90-days of delay. (On a $500,000 construction loan, a quarter point equals $1,250.)

If, by some miracle, the home races to completion faster than expected, borrowers may have to continue making interest-only installments on the loan before they reach the date when they can switch to a mortgage.

Distinct in their terms and structure, construction loans demand collaboration between the lender, borrower and builder. As a result, borrowers may find them confounding. However, due to their niche nature, local custom builders and construction-loan lenders often have long-standing relationships and are well practiced in helping new homeowners navigate the complexity.

“Sometimes the view is, it's a very complicated process from a loan standpoint,” Bolstad said. “It really doesn't have to be.”

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