Author Kevin Daum answers the 10 most-asked questions regarding log-home financing.
As popular as log homes have become, they are still a little misunderstood by the lending community. This situation creates apprehension on the part of loan officers and confusion on the part of the consumers. What may seem like obvious questions to you may be obscure to the bank and possibly even irrelevant.
Part of the challenge is that banks are interested only in educating you to the point where you will take their loan. For the most part, they believe that all you really need to know is their rate and fees. Teaching you anything else about the lending process would only cause you to ask informed questions beyond the scope of the loan officer’s knowledge. Then where would the bank be? Next you’ll probably start asking how construction loans work, and many of the loan officers aren’t even sure themselves.
Well, have no fear. I have compiled a list of questions I am asked on a regular basis, along with actual answers, so that you can begin to understand how to pay for your dream home. This information is basic, but it is enough to give you the edge over the loan officer. Let’s get started.
1. Are log homes hard to finance?
Log homes can be a little more difficult than stick-built homes, but only because there are fewer lenders that will lend on them. Since the Federal National Mortgage Association, otherwise known as Fannie Mae, declared log homes acceptable, more lenders have started making loans on them. There are plenty of large national institutions that will fund, purchase and refinance mortgages on log homes. For construction loans, there are a couple of good ones, but other banks have shied away for the moment. A good mortgage broker can help guide you to log-home friendly institutions.
The biggest challenge with getting loans on log homes has to do with appraisals. Many lenders require information on comparable log homes that have recently sold in the area. Since few log-home people sell their homes, there are not as many comps available. The other challenge is that log-home consumers often over- or under-build for their area, creating value issues on the appraisal.
2. Can I finance my land?
Of course you can. Today, there are fantastic programs available for borrowing on a lot. You can borrow money for anywhere from five to 25 years and at reasonable fixed and adjustable rates that are only a little higher than home-loan rates. Some lenders will loan you as much as 90 percent of the purchase price, and with excellent credit you may not have to show any tax returns. Here is the difficult part. Your lot needs to be less than 30 acres and have utilities to the site. If it doesn’t meet these requirements, then you are dealing with raw land, which has different financing altogether.
To finance raw land or if you have credit issues, you will need a hard-money lender. These private-money people will generally loan up to 50 percent of the value and charge high rates and points. It is still a good way to go if the land is a good deal. One other option is to see if the seller will carry the financing. Often he or she will if it is for a short time.
3. Do I have to wait to pay off my lot before I can get a construction loan?
Absolutely not! In fact, it isn’t even a good idea. You will need a ton of cash to get through a construction project, and every dollar you put into your land will be unavailable. You need money for designs and deposits, not to mention permits and fees. It is better to hoard as much cash as possible before you start construction or take out a construction loan. You will have plenty of opportunity to reduce your loan at the end of the project when you actually know what it really costs. Many people pay off their land and then have nothing left to build or qualify for a construction loan.
4. Do I need a construction loan?
Not if you’re rich as Rockefeller. You can pay your whole project with cash, providing you have enough. You will give up significant tax benefits and tie up your money at a reasonably poor return, but it can be done. If you prefer to be smart with your capital, then a construction loan will be necessary. Don’t fret; these loans have gotten amazingly better over the last 10 years. The best are single-close construction loans that have permanent loans built right in. Many of these loans offer you the opportunity to change rates or loan amounts when the house is finished, leaving you ultimate flexibility.
5. When should I get my construction loan?
Believe it or not, this is not as much your decision as you might think. For construction lenders, all loan documentation expires after 90 days. Since almost all these lenders require permits to be approved, the logical time to apply is not long after you have turned in your plans to the building department for final approval.
It is a good idea, however, to do your loan research early. You can make a lot of mistakes with your project before applying that could result in your loan being denied at application. The best approach is to find a mortgage broker knowledgeable in construction loans that will discuss your situation early on. There may even be choices related to the land financing that could positively or negatively affect your ability to get a construction loan, so start early.
If you have started building already, you can still get a construction loan, but you will need to work with the title company to indemnify the lender against mechanic’s liens from subcontractors and suppliers.
6. How much should I borrow?
This one is simple: Borrow as much as you possibly can. Running out of money during a construction project is the number one, absolute worst thing that can happen. It can result in stalled projects and sometimes even foreclosure. Despite extensive estimates, there is no way to know for sure how much your construction project will cost until it is finished. Many things can happen along the way that may change your cash needs for your log home.
A construction loan acts like a credit line. You draw as you need and pay interest only on what you draw. You don’t have to use it at all and can roll to a smaller permanent loan when the house is completed if you like. But if you take a small loan and use it up before the home is finished without having the cash to finish, you may not be able to get another loan or may pay an exorbitant price to solve the problem. Yes, you will pay a little more up front for a bigger loan, but it is well worth a few thousand dollars of tax-deductible insurance to ensure the financial completion of your log home.
7. What do the banks want to see?
Banks are essentially looking for two things. First, they want to know that the home will be sufficient collateral to secure the money they are loaning. This means they want to make sure the house will be built within the budget and will be a marketable house when it is finished. Red flags for banks on construction loans are things like budgeting too low, over-building or under-building for the neighborhood or building something that only you would ever want to live in. They will set a limit on how much they will lend you based on both the appraised value, as well as the total budget for the house. They will make sure that all the money to complete the project is accounted for before they lend any money. This means you have to bring cash to cover any difference between the cost to build and the loan amount.
The second thing banks want to know is your ability to repay the loan. When the banks evaluate you, they look at three basic areas: credit, liquidity and income.
Credit comes first and is the most critical. Today, credit scoring plays a huge part in loan underwriting. If you don’t meet the required credit scores, you won’t have much else to talk about. The minimum credit score for good rates is 620, but most lenders require scores above 680. If you have a score over 720, you can pick just about any program you want. Check your score early. There are ways to work with your loan officer to increase it by clearing bad marks and reducing credit card debt.
Next, banks look at liquidity. It is just as critical as credit. The banks are not as concerned about the money you already spent as they are about the money in your bank account. They want to see enough cash to fund the project along the way, as well as money for reserves, since these projects are unpredictable. Many times they will need to see as much as 12 months payment in the bank after your down payment is covered. There is no flexibility here. Even if your credit and property look great, you will have to meet the cash requirements to the penny to qualify.
The last piece of the puzzle is income. Banks like to see your total house payment and monthly debts equal roughly 40 to 45 percent of your gross monthly income. However, if you meet the credit and liquidity requirements, you may not have to deal with the income issues at all.
8. How do no-income qualifying loans work?
For decades, banks have been collecting data about who goes into foreclose and why. Today, they use computer modeling to assess which borrowers will make their payments. The banks have determined that good credit, good liquidity and a solid property are far more important than actual income when evaluating the performance of a borrower. If a consumer has these things, some banks are willing to make the loan without asking for tax returns or pay stubs to document the income written on the application. In some cases, the borrower does not need to state an income at all.
These loans can be useful for self-employed people who write down a lot of their income for tax purposes. They can cost a little more, but it’s worth it if you can’t qualify with documentation. Land loans are available this way also, but you need to make sure you present similar information on both loans if you go to the same lender, or you will be denied. A good mortgage broker can guide you through this process.
9. When should I sell my current house?
Many construction lenders do not count the payment on your current residence when qualifying, so this means you do not have to sell first. This will save you the aggravation of moving twice and finding an interim place to live. Most construction-loan programs offer an interest reserve. This stops the need to make double payments during construction. Talk to your loan officer regarding these issues and how they work.
10. What should this all cost?
Construction financing can cost a little more than purchases or refinances. Aside from points being a little higher, you will have higher escrow and title costs to protect the lender from mechanic’s liens. You will also have to buy insurance for the course of construction and liability if you are building it yourself. Four percent of your loan amount should be a good, conservative estimate for everything. It’s likely you can shave those costs, but it is best to keep realistic expectations.
This article by no means represents all the information you will need to finance your dream home, but it does give you a good basis to have meaningful conversations with lending institutions. The log-home process is long and involved and will require a lot of research to ensure you are making the right decisions.
This is your home, however, so don’t be timid when talking to loan officers. Ask them hard questions and make them get the answers. Also, don’t take the answer you get at face value. There is no shortage of loan officers who will make up answers just to get rid of you, especially if they think you are high maintenance. Others will give you half correct answers out of pure ignorance. The best approach is to ask every question three times or until the answers become consistent. This many seem overly redundant, but chances are this project represents your biggest financial asset, liability and monthly payment. For that reason, it should be worth the extra due diligence.
Kevin Daum is the author of the custom-home manual Building a Custom Home for Dummies and What the Banks Won’t Tell You.
This article originally appeared in the 2005 Log Homes Illustrated Annual Buyer’s Directory.