When a construction lender determines whether to do a loan or not, they look at certain factors that will help reduce the risk of lending their money for a construction project. These factors include a borrower’s credit score, cash reserves, Loan to Value, Loan to Cost, and Debt to Income ratios. These factors help the lender determine the borrower’s ability to repay the loan. Because there are so many moving parts during the construction process that can delay or prohibit repayment, the lender will want to have a high degree of assurance for repayment of their loan. The two types of construction loans in the residential market are owner occupied construction loans and spec construction loans.
The first type of residential construction loan is the owner occupied construction loan. These loans are typically paid off by either refinancing through another bank or qualifying with the construction lender for a Construction-to-Permanent loan. When a borrower secures a straight construction loan, the lender will often, as part of the construction loan approval process require that the client be pre-approved for a permanent or take out loan. This is done with the understanding that the pre-approval is to show that the client is approvable at the time the construction loan is originally funded. It does not imply or guarantee that the client will be approvable at the end of the construction process. And, it does not mean that the ‘take-out’ lender will necessarily do the refinance when the construction project is finished. When a borrower secures a Construction-to-Permanent loan, the lender will approve the borrower for both the construction loan and the permanent loan. Usually the only conditions to complete the transition is to complete the house, secure the Notice of Occupancy from the local Building Department and then sign the modification agreements.
The second type of residential construction loan is the Spec Loan, which are for houses built to be sold or to be rented out. For houses that are to be built with the idea that they will be sold upon completion, the lenders will look to the real estate market as their primary source of repayment. The lender will be looking to see that the borrower is building in an active market with a relatively low LTV, which will help insure a quick sale. They will be concerned with ‘time on market’ and sales per month statistics.
Regardless of the type of construction loan, the borrower can be assured that they lender will take the necessary safeguards to reduce their risk of not being paid back fully. Knowing these safeguards is knowing what’s in the mind of a construction lender.