One of the most confusing parts of building a home right now is understanding the way construction loans work. There are differences between the mortgages for purchasing an existing home and mortgages for construction loans. Having a mortgage for an existing home or being pre-approved for a loan does not necessarily mean that a construction loan will be as easy to get.

With loans for existing homes, banks are taking on less risk because they have the house and land as collateral. With a construction loan, there is not yet a house that can be easily sold in the event of a default. And since the credit market has tightened, the kinds of ratios and requirements for equity makes it challenging to finance a new home construction project. Banks are looking for buyers to provide more equity or cash for new construction projects than they have in the past, to balance this risk of default.

The bottom line is that in order to get most construction loans in the current market, typical buyers need about 30-35% equity in the form of cash or existing land ownership.

There are two issues at play here–appraisals and “loan-to-value” ratios. Although down payments on construction loans – or your “equity requirement” – might technically be only 5% or 10%, this presumes you have an appraisal that values your home significantly higher than the cost to build. Appraisals have become much more conservative in the down market, and in addition to that, the loan-to-value ratio at which banks will lend has generally gone from something like 95%, down to 70% or so, even for clients with very good credit.

For these reasons, it is important to understand the constraints of obtaining a construction loan in the current market.

Let’s work through an example to see why.

1) Jane has an excellent credit score of 750 and has a history of fiscal responsibility. She has saved up significant equity for a down payment – let’s say $20,000.

2) With her income level, the bank says that she could probably get approved for an additional $200,000 for the house cost.

4) Once she has all the bids in from her home provider and builder, she is ready to start the construction loan. The loan officer says great, but there’s just one last small detail, the APPRAISAL. Jane is confident the appraisal will be fine because she’s been judicious about designing a house that is within her total approved loan amount.

5) The appraisal comes back and is right at cost goal – the appraised value is $200,000. Unfortunately, however, the bank’s loan-to-value ratio, which used to be 95%, is now 75%. The loan officer explains: “Well, your appraisal is at $200K, and with the credit downturn, we will only loan 75% of that $200K appraisal, or about $150K.” This means that Jane now needs to come up with an extra $30,000 in equity in order to do her $200,000 project

6) Jane tries to get the appraisal up. After taking a second look, the appraiser values the future home build project at $220,000, but does not feel he can go any higher. Thus the bank would now loan up to $165,000 (75% of $220K).

7) In the end, Jane has to find an extra $15K in equity to do her project, OR try to create a project that will cost less but still be highly valued. This is obviously hard to do as it presumes that you can PLAN to build a house that will be worth 20-30% more than you pay for it. This does not usually work in free markets.

In effect, the banks’ lower loan-to-value ratio means that their construction loan portfolios decrease a great deal.

In general, in this economic environment, it is much easier to get by this loan-to-value ratio issue if you already fully own land or have a significant amount of equity in your land, as the equity value of that land is included in the calculations.

If you do not own land and have only about 10% equity, as Jane did, it is going to be hard to get a construction loan. In effect, in the current environment most buyers need the equivalent of about 30-35% equity in either land or cash, in order to do a construction loan through most banks.

The market environment is changing all the time, so it may be that the lending environment will get better in the coming years. But as long as the credit market is tight, it is better to be prepared, so that building your dream home is an easy and fun process!