As home buyers find it more and more difficult to jump into the housing market, the industry looks for more ways to smooth the path to homeownership while not putting new homeowners in jeopardy or creating a new financial crisis.
A prospective home buyer who wants to build his or her own home has been stuck with having to take a very high-cost construction-to-perm loan, or pay for financing twice within a very short period of time — once for the construction loan and once for the permanent loan.
Fannie Mae may have just come up with a solution — and it involves new home construction. To understand the agency’s proposed change, we must first look at what makes building your own home such a bear to finance.
A Typical Scenario: Two Loans for One Home
The trouble has been that most lenders who specialize in construction loans are set up to make short-term loans — just long enough to build the home. Once construction is complete your lender has to be paid off, typically through a new conventional loan. Essentially, you are financing construction with one loan, and then refinancing it into a permanent loan.
A Single-Loan Solution — With a Down Side
A few lenders have tried to solve this problem with construction-to-perm (permanent) loans.
This process is difficult for the lender to manage, however. A lender sells virtually all the loans it makes, and prices them to sell them within a specific time frame — for example, 60 days — based on what the investor (Fannie Mae, Freddie Mac or a Wall Street hedge fund) says it wants to make on the deal if it is ready to buy before the end of that period.
The time it will take to finish construction, however, is not always predictable. An investor won’t purchase the loan until after construction is complete, and guessing when that will be is not easy.
Lenders who offer construction-to-perm loans thus must hold on to loans for months before being able to sell them. If interest rates rise during this time, the value of the loans drop dramatically, and the lenders could lose money. Lenders who offer this kind of loan, therefore, have to price that risk into the loans. As you can imagine, they’re not cheap.
So a prospective home buyer who wants to build his or her own home has been stuck with having to take a very high-cost construction-to-perm loan, or pay for financing twice within a very short period of time — once for the construction loan and once for the permanent loan.
A Better Solution That Strips the Complication
Fannie Mae is proposing a very simple new rule that could be a huge game-changer. Rather than making the lender wait until the construction is completed, Fannie is proposing that it buy the loan as soon as construction starts.
The lender will manage the construction portion of the loan, meaning it holds on to funds until certain milestones are reached and pays your contractors only upon completion.
This means that a lender could make the loan without taking on the risk of holding it for an unknown period of time while construction is completed. The lender still has to manage the construction portion of the loan, meaning it holds on to funds until certain milestones are reached and pays your contractors only upon completion. You’ll have to pay for this additional administrative layer, but you won’t have to pay for the risk of interest rates moving.
Fannie Mae has proposed the new rule to its regulator, the Federal Housing Finance Agency, which has yet to approve the concept. The agency would no doubt test it out on a small pilot program at first under tightly controlled circumstances, too, so it won’t be widely available anytime soon.
Developers who build entire tracts usually have their own construction financing in place, so this won’t have any impact if you are buying a home from a developer in a new subdivision.
In fact, only a very tiny portion of home loans are made to people who build their own new homes. The number of home buyers this could affect is therefore very small. The question is: Would more people elect to build their own homes if the costs and hassle of financing new construction were lessened?
Fannie Mae is betting “YES.”