How to Offset Costs to Obtain a Construction Loan from the Bank
I want to share how you can use a cash-out refinance on your primary home that you’re living in now to help you fund a construction loan for a new home. This also applies when you need a little cash because an appraisal comes back a little low on a new construction project. You can offset the cost in order to obtain the construction loan from the bank.
Construction Loan for a New House
I have an example of a current project with current numbers. We submitted the lender package which includes a cost breakdown, specifications for the home, a set of plans, and now they can complete an appraisal based off of cost to build or cost after completion. So this home’s appraisal has not yet been completed. We’ve run some internal comparables on this property and believe the completed value will be about $1.3 million. Let’s take a look at some numbers based on that $1.3 million valuation.
Calculator
The actual building costs are going to be about $1.2 million. There are some higher end finishes in this home. Sometimes you don’t get the best ROI when you do higher end finishes on a resale value. This sometimes requires obtaining extra money to make up the difference. In this scenario, we have $1.2 million with a potential appraised value of $1.3 million. The bank will not loan more than 80% loan to value on the construction loan. 80% of $1.3 million equals a $1,040,000 loan amount, resulting in a $260,000 equity position to the owner. Remember that the bank considers the value of the land that you have plus any prepaids that you have for construction costs.
If the bank needs $260,000 down on this property, that encompasses the following:
- $130,000 purchase price for the land.
- The $26,000 in prepaid construction costs.
Equity Position
For this particular home, the owners have $156,000 into this property that the bank will count towards the $260,000 down payment. After deducting the $156,000 from the required 20%, these owners must come up with $104,000 in order to make up the difference. That cash must get to the construction lender prior to the construction loan close of escrow.
Primary Residence Leverage for a New Home Loan
The current primary residence is roughly $800,000. Their first mortgage is approximately $400,000. Their current home equates to about 50% LTV. A cash out refinance on the primary residence usually allows a max of about 80% LTV. Now they only need $104,000 and therefore obtain a cash out refinance on this property. Putting fixed straight debt onto the construction at a low interest rate is permissible because the debt is on the primary residence. Before closing costs, the original $400,000 is now roughly $504,000.
The primary residence now has about a 63% loan to value. 63% is well below the allowable 80% on a cash-out refinance and frees up the $104,000 needed for the property. Once they re-amortize the loan at the new rate, it will increase the payment. If the owners can cover that payment when they move into their new property after final inspection, they could still have a cash flowing property after pulling out the cash to use on the new project.
Debt-to-Income (DTI)
The Debt-to-Income ratio is important to consider. Lenders consider whether or not you keep the debt on the previous property. They know what you’re doing with that money, and they’ll consider the old home as rental property. The bank in this particular situation does that and counts a percentage of the rental income towards their DTI Ratio. 25% of the rental revenue comes off the rental income and that helps offset the mortgage on the primary residence.
Home Project Resources
I hope that helps you understand some of what you can do with a cash-out refinance if you need to come up with a down payment or a little bit more cash to make your construction work fund. If you’d like more information on how to buy land, buy a home, how to build a home, how to build an ADU, or how to remodel your home, take a peek around the website, we have a ton of free information under our resources tab.
Take a look at our comprehensive collection of similar videos on our YouTube channel, The Real Property Show.
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