It’s financing from the ground up.
Affluent home buyers are building their dream mansions by signing up for jumbo construction loans that cover extravagant projects, including indoor swimming pools and multicar garages. Some are using construction loans to build their vacation homes. And others are using them to pay for major renovations, like adding extra bedrooms or extensions, to their existing homes.
A construction loan is basically short-term financing that covers building costs while the work is in progress. Demand for these loans among the wealthy dropped after the recession as home values fell. But the tide is changing. “Overall, there’s a general uptick—the market has been coming back,” says Kim Casaday, president of the home-financing division at Zions Bank. The Utah-based institution has seen originations for jumbo construction loans increase 15% during the first eight months of this year compared with the same period a year prior.
Deep Deshpande at his home in Brookline, Mass.
TD Bank says originations for its jumbo construction loans, which it provides along the eastern U.S. coast, have risen 110% in number year to date. Boston Private Bank & Trust Co. says its jumbo construction loan originations increased by 35% in the San Francisco Bay area from January through August compared with the same period a year ago. In response to rising demand, the bank introduced construction lending to its Southern California clients last month.
Lenders say the pickup is partly due to limited housing inventory in many markets. Rather than choosing from the small number of listings that are for sale, wealthy buyers are building their own homes.
Deep Deshpande and his wife recently moved into their Brookline, Mass., five-bedroom, 3,500-square-foot home, which they built from scratch with a $1.25 million construction loan from Boston Private Bank. Mr. Deshpande, chief financial officer at a staffing company, says financing allowed the couple to build their dream home, complete with a seasonal outdoor skating rink and heated patios.
In most cases, those planning to build their own homes buy land and hire a contractor to build on it. If a contractor has lined up his own financing to build the property, the buyer may just need a standard mortgage after the home is completed. But small or specialty contractors often don’t have that front-end financing, says Stephen Melman, director of economic services for the National Association of Home Builders. That leaves buyers with two choices: pay cash or apply for a construction loan.
Types and terms of construction loans vary, but one of the more popular products is a one-time close construction loan or construction-to-permanent loan. It covers building costs and then becomes a regular mortgage once the home is finished. During the building phase, the loan acts like a line of credit that can be tapped each time more funds are needed to proceed with the project. Since the loan covers pre- and postconstruction financing, there is only one application and one closing.
Part of the loan’s appeal is that it helps borrowers with cash flow, since they typically just make interest-only payments during the construction period on the amount that has been used at that point. Once construction is completed, monthly principal and interest payments are due. In some cases, the interest-only payment period exceeds the construction period: At Boston Private Bank, for example, it lasts the first 10 years of the loan.
The loans can also offer interest-rate protection. Some lenders allow borrowers to lock in their rate from the time of application (before construction) with a 30-year, fixed-rate mortgage.
Despite their perks, the loans aren’t always easy to navigate. To figure out how much to lend, banks will have an appraiser determine how much the home will be worth once it is completed. Borrowers in most cases are required to make at least a 20% down payment, which can be in cash or in equity based on the value of the land (assuming they own it) the home will be built on.
Here are a few more issues to consider:
• Appraisal setbacks: Lenders will provide financing based on the appraised value of the home. Appraisals can come in significantly lower than the cost of building a home if most other homes in that market are of a lower caliber. To get the loan, borrowers will have to make a larger down payment.
• Extra fees: Before signing up, look out for extra costs, including a fee incurred during origination, which can be 1% of the loan amount. Also, some lenders charge a penalty fee to borrowers who pay off the loan or refinance it with another lender early.
• Interest rates: Some lenders only offer adjustable-rate mortgages with this product. And some charge interest rates that are roughly a quarter of a percentage point higher for these loans than for regular private jumbo mortgages.
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