Construction Loan Basics

by | Jul 9, 2021 | Financing, How-To

For many log, timber frame, or hybrid homeowners, the most daunting task in completing the purchase or construction of their ideal residence is dealing with financing. Although economic pressures have weighed on the market and banks have often been described as reluctant to lend, even during the best of times obtaining a loan for a log, timber frame, or hybrid home requires planning, patience, and understanding of the necessary steps.

While the processes of financing conventional and log, timber frame, and hybrid homes share similarities, securing a loan for a specialty home has some requirements and nuances all its own. “There are only two major differences,” explains Troy Kennedy of Wells Fargo Home Mortgage. “Otherwise, the products and the process are exactly the same. First is the prepayment of log, timber frame, or hybrid home packages for construction projects. Most manufacturers require that 50 percent of the package be paid for up front prior to manufacturing and that the remaining 50 percent be paid upon delivery to the job site. This differs from a conventional home where draws cannot be paid for materials until the house is fully framed on site.”

Andrew West, vice president and wealth management adviser for Mounier, Larson, West & Gasparini Group in Rockford, Illinois, agrees. “The construction department at a bank has a standard procedure for disbursements of funds, and on conventional construction loan draws are made as the home is being completed. In log, timber frame, and hybrid homes you’­ve got a lot of cost before the product arrives, and since the log or timber company is cutting a project for you they will want 50 percent of their cost paid before they turn the saw on. So, it is best to determine if your bank is experienced in log, timber frame, and hybrid home financing and willing to work on such a basis. This means asking the question, ‘Are you willing to disburse money when I say so and not when the bank says so?’”

According to Kennedy, the second major difference with specialty home financing involves the appraisal process. “Conventional appraisals require similar properties sold within a very short distance and within a very short time—typically within the last year,” he comments. “Log, timber frame, and hybrid home appraisals have to be more flexible to go farther out in distance and farther back in time. Also, appraisers need to recognize that there may not be many such comparable sales and allow custom-built conventional homes to be used in the appraisal.”

An additional factor in the appraisal process involves the homeowner’s plan itself. When the decision is made to build a log, timber frame, or hybrid home with financing involved, buyers should consult with their team of professionals, including the builder, architect, and interior designer to determine that the home fits the profile of the development or other anticipated location. Consider the size, style, and cost of other homes within a radius of several miles. Is the contemplated project similar in cost and style? If not, there may be concerns with appraisal and resale values.

In other words, if the project is overbuilt or underbuilt for the area, the appraisal value will be affected. For example, a timber frame home constructed in proximity to other timber frame homes of similar size and with comparable amenities should appraise well.

Bearing these basic concerns in mind, the process for financing a log, timber frame, or hybrid home is similar to that of a conventional home. Most lenders will offer standard options of up to 30-year terms and a loan amount of up to 80 percent of the appraised value or sale price of the home, whichever is lower. In the case of construction, loan to value is often restricted to 75 percent due to the additional risk of the construction period.

Certain lenders will provide construction financing on a short-term basis only, typically allowing six months to a year to complete the project; however, construction-permanent loans that involve a single closing and simple conversion to permanent financing are available, eliminating the need for more than one loan and a second closing.

Understanding the basic steps of log, timber frame, and hybrid home financing takes the mystery out of a process that most people will encounter only once or twice in their lives. Preparation is essential.

Get prequalified. Greg Ebersole of Susquehanna Bank says, “Today the most important step is to get prequalified to ensure the client plans from the start a home that is within their budget and has the necessary down payment available.”

Work with a log, timber frame, or hybrid home company and builder to finalize costs. “What size home fits well on your balance sheet as a financial item?” says West. “Knowing that in advance gives you confidence in the design and how much you can spend. Builders and others will want to know what your budget is, so keeping it a secret is silly. Definitely have someone in the process you can trust and say, ‘This is what really works for us financially.’”

Work with the lender to obtain loan approval. “Have all of your financial information ready, including tax returns, pay stubs, and bank statements,” says West. “The lender will take an application and begin underwriting. The more organized you are, the better. You have to be employed and have assets and be able to prove you can pay the loan back. You need to demonstrate that you are a good saver and don’t have a lot of debt. Cash is important in construction because you need to be able to pay for something unforeseen such as running into rock that would make digging the foundation more expensive than originally planned.”

Close the loan and begin construction. Kennedy advises, “After getting a preliminary preapproval, the borrower delivers information including plans and contracts with the log or timber provider and the general contractor, and documentation on income and assets. With construction loans, the builder is qualified and then counseled on the draw process. An appraisal is received, and final numbers are determined. Loans gain final approval and generally close in approximately four to six weeks.”

Each of these basic steps in the financing process involves attention to detail and awareness of some potential pitfalls. For example, borrowers are evaluated on the basis of their cash flow cushion, or ability to repay a loan based on income and expenses. A strong credit history and stable income are essential. Appraisal value dictates the actual dollar amount of a loan. So, while a borrower may be able to repay a larger loan, the amount borrowed is restricted by the appraised value of the property. During prequalifying and final approval, self-employed borrowers are limited to the adjusted gross income reported on their tax returns. So-called low-doc or no-doc loan programs were once readily available but are now less common.

“Some lenders may have higher credit score requirements for construction loans,” notes Ebersole. “Others may lend at lower loan to value due to unfamiliarity with log homes.” Actual construction should never commence prior to closing and the issuance of a title insurance commitment to prevent issues with prior liens. Deal with qualified professionals. An experienced lender and licensed general contractor will ease the completion of details such as permitting and coordinating subcontractors and materials.

Ebersole dispels the myths that log, timber frame, or hybrid homes are difficult to finance or that interest rates for these homes are higher. “It comes down to finding a lender who has a comfort level with these types of homes. Some lenders may charge a higher rate because of their inexperience in handling log, timber frame, or hybrid homes, but if the client is working with a log or timber-home friendly lender this is not true.”