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Doing The Math
Kevin J. Daum
This article was originally published in a 2006
edition of Log Homes Illustrated magazine.
There are many different ways to finance a log home project. The one thing they all have in common is the need to do mathematic calculations. No need to go running for your scientific calculator or pull out your old college calculus textbook. Most of the math formulas used in lending won’t go past basic multiplication, fractions and decimals.
There are however some common calculations used by most lenders that are important for you to know when financing a log home. These formulas will determine how much money you need to qualify, how much interest you will pay and how much you can borrow. It’s best to understand how the lenders see things early in the process so I have exampled most of these formulas below for you to work with on your own project.
Contingency – Most lenders when calculating how much your project will cost want to make sure there is some sort of padding in your budget. Adding this contingency is important since shocking as it may seem not every project comes in on time and on budget. The lender is concerned about their worst case scenario of you running out of money in the middle of the project leaving them with the half completed home and not enough money left over in the remaining loan to finish the house.
The amount of contingency required varies from lender to lender but is usually between 5 and 15 percent of the hard costs of construction. The lenders will often exclude the cost of a log package as well as the cost of the permits in the calculation. For example, if your cost of construction excluding the land, log package end permit fees is $350,000 and the lender requires a 10 percent contingency the math would look as follows; 350,000 x .1 = 35,000 and your contingency would be $35,000
Interest Reserve – If you have worried about how you will cover both the payments of your construction loan as well as the home in which you live, never fear, the lenders have taken your concerns under consideration. Most construction loans either require or allow the option of an interest reserve to cover the interest payments during construction.
To calculate the typical interest reserve you first take the loan amount and multiply it usually by 60 percent. You account for this reduction because a construction loan acts like a credit line and you don’t use it all at once. Since you only pay interest on the amount you have drawn, there is no need to reserve interest on the whole amount.
The reduced loan amount is then multiplied by the interest rate to get the number for the annual interest. This number is then divided by 12 and subsequently multiplied by the number of months for the construction loan term. In the following example a borrower takes out a $500,000 loan at 8 percent for a building term of 9 months. The math looks like this;
500,000 x .60 = 300,000
300,000 x .08 = 24,000
24,000 divided by 12 = 2,000
2,000 x 9 = 18,000
The interest reserve for this example would be $18,000
Points – The least favorite part of any loan is the closing costs. Of these costs Points remain the most mysterious. Points are fees paid to the lender to reduce the interest rate. Most construction lenders will charge between 1 and 2 points for the loan. From these points the loan officer will get paid. 1 point is equal to 1 percent of the loan amount. Points are usually expressed in fractions of eighths or decimals. For example, a loan may cost 1 5/8 or 1.625 points.
The math for figuring points is simple. Simply multiply the loan amount by the percentage points to get the fees you are going to pay. For example, If you are being charged 1 3/8 points on a $400,000 loan the formula would be 400,000 x .01375 = 5,500. The amount of the points would be $5,500. Of course there would be other fees as well including escrow, title, insurance and others so you will need the lender to give you a Good Faith Estimate of all closing costs to calculate the total costs.
Loan To Value – Regardless of the cost of your project, the lenders will determine your loan amount primarily by evaluating the security for the loan which of course is the home you are going to build. The lender will determine value by hiring an independent appraiser to compare your plans and lot against similar homes that have sold in the area. The lender will then multiply the appraised value by the percentage they are willing to lend. This percentage can vary from lender to lender and based upon other criteria such as the size of the loan, your credit and whether or not you require a No Income Verification loan. Most lenders will loan roughly 80 percent of the finished value.
Here is an example of the math. If the appraised value is $500,000 and the lender will loan 80 percent, the formula would be 500,000 x .80 = 400,000. In this case the loan amount would be $400,000
Loan To Cost – One of the ways lenders evaluate how much you can borrow is to look at the cost of your project. Lenders want to evaluate the total cost to build including land, soft costs including permits plans and fees, hard costs or board and nail, contingency, interest reserve and closing costs. Some lenders will loan 100 percent of these costs as long as the loan amount meets the LTV guidelines. Some lenders however will only loan a smaller percentage of the costs.
As an example, if a total cost to build for a project is $625,000 and the lender is only willing to finance 80 percent of the costs than the calculation would be 625,000 x .8 = 500,000. Since the borrower in this case could only get a loan for $500,000 they would subtract the loan amount from the total cost like this; 625,000 – 500,000 = 125,000. $125,000 would be the amount the consumer would need to bring to escrow to close the loan.
Cash Reserves – Liquidity is the most critical aspect of qualifying for a construction loan. Lenders want to see that you have enough cash to fund the project while waiting for draws and extra cash in case the project goes over budget substantially. Lenders generally evaluate your cash in terms of payments you will be making on the loan.
Lenders can require anywhere from 2 to 18 months payments for cash reserves. When evaluating your reserves they will look for cash, stocks and mutual funds. Lenders will only give you 50 to 70 percent credit for any funds in retirement since if you liquidate these funds you will have to pay taxes and penalties. Equity in homes or in your lot is not counted as cash reserves.
Calculating cash reserves is fairly simple. You will have to estimate an interest rate and find out the amount for the local property taxes for an accurate assessment. In the following example the loan payments are calculated based upon a 6 percent interest only loan of $425,000. If the required reserves are 6 months you could calculate as follows; 425,000 x .06 divided by 12 = 2125. If the tax rate is 1 percent and the value is $525,000 you would calculate the 6 month taxes as 600,000 x .01 divided by 12 = 500. Now add the taxes and the payment together; 2,125 + 500 = 2625 and multiply like this 2,625 x 6 = 15,750. $15,750 would be the amount of cash reserves required to qualify for this loan.
Debt to Income Ratios - Income is playing much less of a factor these days when qualifying for construction loans. No Income Verification (NIV) loans have become the norm for self employed and commissioned people as well as consumers who have erratic bonus structures.
Even though NIV loans do not require pay-stubs or tax returns, the lenders still calculate debt-to-income ratios as the percentage of income used to cover the housing debt. Debt to income rations are often discussed in terms of front end and back end rations. The front end is only the housing payment divided by the gross monthly income. For the back end ratio you have to add all of your other monthly payments such as credit card and car payments.
Using our example of payments from the reserve section, let’s assume that the borrower makes $10,000 per month and has a car payment of $400 per month. First you would calculate the front end ratio like this; 2,625 divided by 10,000 = .26 or 26 percent. Next add the car payment to the housing payment 2,625 + 400 = 3,025 and calculate as follows; 3,025 divided by 10,000 = .30 or 30 percent. These would be perfectly acceptable ratios since most lenders are happy as long as the back end ration is less than 45 percent.
Look for Hidden Numbers – There are other equations in construction lending that are used only under certain circumstances. Work with your Loan Officer to examine all of the calculations involved in your loan. You may find some surprises. Recently I stumbled across a lender who had recently changed their policy regarding funds deposited into escrow at closing. When a borrower deposits money to make up the difference in costs, most lenders will use this money first before drawing on the construction loan. This lender however uses the borrower’s money last. This results in the consumer paying more interest over the life of the loan.
In this case the borrower borrowed $500,000 at 8 percent and brought in $100,000. Using the interest reserve calculation to figure the excess interest on the deposited funds we calculated as follows; 100,000 x .6 x .08 = 4,800. $4,800 was the additional interest that the borrower would have had to pay, the equivalent of almost 1 point. This policy made the loan from this lender more expensive then others even though the upfront points were less.
Luckily you don’t have to be a rocket scientist to manage all of the mathematics for construction financing but it is important to investigate all of the formulas for lending, construction and taxes with your Loan Officer, Contractor and Accountant. This way you can feel confident that all of your financial decisions for this project will be well calculated.
Kevin Daum is the Founder and CEO of Stratford Financial
Services, a Real Estate finance and education company, founded
in 1989. Stratford specializes in Purchase loans, Refinance
loans and Custom Home Construction finance and has successfully
financed thousands of clients. He is the author of "Building
Your Own Home for Dummies" (Wiley), as well as "What
the Banks Won’t Tell You." Mr. Daum was an Underwriter
for Plaza Savings and Loan and Key Bank of New York. He is
an INC 500 CEO and has been listed as one the 40 Most Influential
People Under 40 in the San Francisco Bay Area. He is the Global
Chair for the Edison Innovation Program with the Young Entrepreneurs'
Organization (YEO) and is a founding Board member of the Bay
Area Chapter of YEO.
Mr. Daum is a frequent contributor to numerous business
publications on the subjects of Real Estate and Small Business
leadership and speaks regularly on both subjects. He can be
contacted at kevin@stratfordfinancial.com.
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