We needed to get a construction loan for our project. We used Umpqua bank for the financing. So much education is about to happen. This blog post will probably be held up as the definitive guide to construction loans and how to maintain good financial health for generations to come.
I have a lot of ideas and thoughts. Sometimes I get reality confused with stuff I make up in my head. When I was young, before I got super smart, I tried to build an underground house by digging an elaborate set of tunnels. My underground house had fireplaces dug into the walls which I could use for both warmth and light. I learned proper underground construction technique as I went. For instance, I learned that fireplaces need chimneys and you can pass out if you inhale too much smoke. I dug a long tunnel underneath the neighbors cinder block fence and it collapsed on my underground home doing substantial uninsured damage. I had to dig myself out and then lost interest in the project in favor of a submarine I tried to build using an old Ford Fairlane.
The point is; I know how to get shit done.
For the Going Queen project, I wanted to act as my own general contractor. I felt I could pull that off. I took off down that road, put plans together, lined up all my subcontractors, got estimates and was ready to go. My plan was to get a little money from the bank to get started. After that ran out, I would spend the money Jenny I had saved and see how far that got us. And then maybe later, call up the bank and tell them to send some more money over. My plan was pissing Jenny off but I was all confidence.
The bank said no to that plan.
Apparently, they have some prior experience with loaning money to homeowners and there is a process to follow. They said they would only lend to me if I had a general contractor. They also said I had to borrow the full amount for the entire project right up front. Frankly, they sounded like my mom. They even said it was for ‘my own good’.
I didn’t understand why at first, but now I do. I’ll come back to that, but let’s talk construction financing.
Just like with a home loan, the bank will loan you up to 80% of the appraised value. You, the buyer/home owner, provide the other 20% or the property must have that much equity. The reason for this is obvious… if you default on the loan, the bank can expect to sell the property in foreclosure and recover all their money. If they loaned you more than the property is worth, they would risk their money.
Construction loans have the same requirements, however in a construction loan, that is based on the future value after the construction is complete.
For our loan, we needed to borrow an amount equal to the whatever we owed on the Going Queen from the original purchase + the total cost of the remodel. The math on that is $546k + (604K * 10% contingency) = $1,210,1000. Because you can only borrow 80% of the value, the appraisal had to come in at $1,512,500.
Let’s just stop here for a moment and acknowledge that probably isn’t going to happen.
As you can see, we had a problem. The appraised value came in at $1,306,000.
This wasn’t going to work. We needed something to change. Our options were:
Challenge the appraisal and try get a higher valuation
Reduce the remodel budget to $450K
Make up the difference between the amount we could borrow and the proposed project budget which came to about 180K
We kicked the tires of challenging the appraisal but it was obvious we weren’t going to move the needle much. We might be able to provide some supporting evidence that would cause it to increase by 1% to 2% but the 15% increase we’d need to get the loan.
We already knew reducing the project budget wasn’t happening because we’d already done everything we could there.
So, we had to look at putting in more cash or calling this off. Frankly, it was looking grim. We started leaning towards calling it off and started figuring out what that would look like. As you can imagine, we’d discussed this many times over the last two years whenever we’d come up against an obstacle that called into question the sanity of this project.
Our options for bailing looked like this:
Demolish the house and build a new one
Sell the property as-is to make it someone else's problem
Convert this to an investment property and redevelop it for resell
All of these were undesirable. We didn’t want a new home, and if we did, there were easier ways to get one. We didn’t want to be responsible for demolishing this house either. We also had no emotional energy for starting over and designing something we weren’t really into. Not to mention, it was likely we’d still be in the same situation where the cost of construction would be greater than our ability to borrow.
Selling it as is seemed doable, but we were going to take a huge financial loss on that. We have already put about 100K into this project for the initial clean up, demolition, design and engineering work. We purchased it at 700K, and that is an amount that only makes sense if you are going to remodel this place. As bare lots, it’s probably worth about 550K. So, if you consider the cost of demolishing and clearing the lot at about 50K, the loss of the 100K we’d already invested, and the difference between what we paid and the value of bare lots we were in for a beating to the tune of about a 300K loss.
Converting it to an investment project would likely be a break even opportunity. It might even net a small profit. Just a few blocks away from us on, on 23rd and Wygant, there are a pair of duplexes and a single family home on a lot that is about the same size. The duplexes each went for 1.15M and the single family is at around 750k. If we went this route, we’d have 3M in potential value to work with. If we could keep constructions costs to about 2.3M we’d be able to break even on.
But, that would tie us up for the next two years in a construction project we wouldn’t care about and would carry a lot of financial risk.
Not the least of which is all of these options suck. They suck for us, suck for the neighborhood and are sucking the soul out of me just typing this right now.
We decided that the best way to think about the situation was in terms of skydiving.
About two years ago, we decided to jump out of an airplane and we are now on the way down and encountering a bit of trouble. Let’s say our chutes didn’t open and we are discussing options, like not skydiving or skydiving on a different day. These options aren’t really available to us. We should stop wasting time and pull the emergency rip cord… and finish the dive.
So, we started looking for the 180K we were going to need. The first 100K was obvious.
Remember from the last post, we’d saved this amount of money for the project and we ‘spent’ it by pulling $100K of costs from our construction budget with the plan on spending that cash on these items. Recall that these items include things like tubs, tile, faucets, lights, heating & cooling and things of that nature. We are going to have to find another way to purchase these things.
The 100K we saved is now going to have to be spent on things like pouring a new foundation. For the other 80K we were short, we looked around for things of value, other forms of savings like retirement monies, and made it happen. Some of the choices we made created financial challenges for ourselves that we’ll have to fix in the future. And of course, at least as it sits right now, our house will have no lights, toilets or faucets. Minor issues for another day.
We told the bank we were moving forward. They said great and asked for a check.
I thought we’d have more time to find this 180K and I thought we’d be able to hang on to it for a while. Not so.
This was another thing I learned about construction loans. When you, the owner, are contributing money to a construction project, you have to give to the bank up front. We had to write that check right away. I thought we’d spend the banks money first, then spend ours. The bank preferred we do it the other way.
The loan was funded.
Construction loans are typically Adjustable Rate Mortgages (ARM). This is because you won’t know what the total amount borrowed is until you are done. The loan works like a line of credit where the loan amount is the maximum you can spend.
ARM loans carry more market risk for the borrower because the interest rate can change. Typically, an ARM has a lower monthly payment at first, then it goes up over time. They can be good if rates are going down and home prices are going up. They can be murder if rates climb and home prices stagnate or fall.
I remember in the 80’s when interest rates were really high. My sister bought a sweet ass white Pontiac Fiero in 1984 and was paying 22% interest on the car loan.
She was working at a catering company near where we lived in Southern California to earn money to make the payment. One weekend, she was off doing an event former Secretary of State Henry Kissinger. A friend picked her up so she left her Fiero in the driveway. I needed gas so I put a hose into her gas tank with plans to suck on it until the gas came out. Once it started flowing, I planned on putting the other end into my primer-gray VW Bug. Unfortunately, I didn’t get the hose far enough in so when I sucked, I inhaled the fumes from the Fiero’s tank. I took a dirt-nap in the driveway until my sister found me unconscious with a hose hanging out of my mouth. She was really mad at me. Not only for trying to steal her gas, but also because I was wearing her eyeliner and her Wham! Choose Life t-shirt. It was the 80’s. Interest rates were high.
I know that can happen again.
Here’s the closing disclosure statement for our loan:
You can see it starts out at $2,100 a month (cool beans), then it goes to $5,500 a month (mmmm, ok), and then if I’m still sitting on this loan after 10 years it could go to $8,000 a month. So, obviously we have to refinance this thing at some point. But, you can’t predict the future. The housing market, interests rates or personal ability to borrow may have changed and this could turn into a turd sandwich.
Another difference between a normal mortgage and a construction loan is that your builder is involved in your loan. With a regular mortgage, it’s between you and your bank. With a construction loan, you have a three-party contract between you, your bank and your builder.
In fact, this money we borrowed is now sitting in a bank account at Umpqua. We don’t have access to it. Umpqua pays the builder. The builder has to submit draw requests against individual line items on the construction budget that we agreed to. If we go over budget, the money comes from the 10% contingency fund.
The bank has provided some software to help keep track of the project financials:
When the builder wants to be paid, they use this same software to submit their request along with all the supporting information. The request gets routed to Jenny and I, and we review and approve it. It then gets routed to the bank, where they sent an inspector out to look at the project and confirm the work is complete, then they approve it and the builder gets paid.
It feels like great system and eliminates a lot of the risk and potential bullshitery that can occur in a construction project.
So, there you have it. All the details of how we are paying for the Going Queen project.
So what did it cost?