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What to Review When Originating a Residential Construction Loan
Residential construction is the development of real estate for living whereas commercial building is intended for commerce. Traditionally, community banks handle the vast majority of residential construction loans. These are local or regional banks whose assets generally fall short of $1 billion, especially in the case of loans for single-family homes. Larger banks may also deal in residential construction loans, especially for larger housing projects, but their primary focus is commercial and other non-residential construction.
There are two major types of residential construction loans:
- Prearranged permanent financing – In practice, large-scale residential projects require permanent funding because banks need to limit the risk of overextending the capacity of the contractors.
- Spec Loans – Speculative home loans are typically utilized for single-family home projects since they offer flexible solutions for builders without secured sales, such as flexible draw schedules, interest-only payments in the construction stage, and the option to employ land equity for a down payment.
Let’s take a look at the entire process of originating a residential construction loan, from the moment you apply down to the fund’s disbursement.
Residential construction loan origination involves a thorough investigation of all related parties, including their expertise, financial standing, and reputation. The borrower will be expected to meet the lender’s predetermined conditions. These conditions may vary from one institution to the other, but they generally include a combination of the borrower’s history and reputation, as well as his or her ability to meet the financial requirements of the agreement.
The contractor of the residential project will also go through a thorough review. Before reaching an agreement, the lender will look into the contractor’s experience, previous work results, and the financial stability and overall health of the business. This due diligence will require a substantial body of documents which serves to safeguard the lender and guarantee that the contractor is capable of completing the residential construction project per the project proposal.
The primary risk factor on the side of the lender is the fact that the value of the collateral property does not yet exist upon issuance of the loan. That is why the lender will take every available precaution to remove any outside risk to the planned construction serving as collateral. The bank will consider the marketability of the finished project in changing market conditions. The standard safeguards in a project’s assessment include a construction agreement, records of a first mortgage, an acceptable appraisal, and inspection reports, among other documents.
Aside from periodic third-party inspections throughout the construction process, the lender may require additional progress reports, particularly in the case of more substantial construction projects or tract projects. In the case of tract loans, the necessary documentation may include a master note for the whole project, as well as a master deed of trust or a mortgage that covers the entirety of the land encompassed by the project.
Depending on state laws, both the lender and the contractor will have varying degrees of protection, with certain legislatures favoring one or the other. The services of an experienced construction loan admin can ensure that the origination of a loan runs smoothly in all stages, without any missteps or complications.