Custom Construction Loans Put Credit Unions in Foreman's Seat
Despite potentially more complications, lengthier time lines and higher risks, more credit unions have begun financing the construction of new homes.
“There really isn’t any rhyme or reason about which credit unions offer these loans,” said John Murphy, mortgage manager for the $453 million Consumers Credit Union in Kalamazoo, Mich., which serves 52,000 members.
“It isn’t a matter of size because some of the biggest credit unions, such as Navy Federal, don’t make these loans. Credit unions that do so make these loans because they have members and a market looking for them.”
A custom construction loan is a loan that a credit union member will take out for the purpose of building a new house. Custom construction loans do not always include the cost of the land where the new home will be located. Sometimes, the credit union is involved in many aspects of the home’s construction including being in on the types of materials used to the contingency plans for unforeseen construction circumstances.
Even though most custom construction loans end up as straight mortgage loans, whether in the credit union’s portfolio or sold on the secondary market, they differ from standard mortgages with their typically longer processing time frames and their involvement of more parties, Murphy added.
There is another distinction between custom construction lending and straight construction lending, he noted. With the latter, builders construct homes on their own accounts for sale later in a way that is more akin to a type of business loan than a mortgage loan.
“Custom construction loans really are a unique product,” Murphy said, “and, it’s not surprising that a big a credit union, or even a bank, might not offer them. They might have other lines of business that are every bit as profitable without being as risky or taking as much time.”
The time factor was a major source of risk and difference between custom construction financing and other housing finance, Murphy explained. In most regular mortgage situations, a loan might close in a month and borrowers tend to want the lending process people to close as quickly as possible. By contrast, while a custom construction-financed deal might close quicker, it might take six, nine or even 12 months to finally convert the loan to a mortgage loan.
Custom construction lending differs from regular construction lending in that members apply for the loan to build the homes they are involved in designing and building.
This extra time and other potential lending complications led Murphy to seek out other credit unions with custom construction experience at the recent annual meeting of the American Credit Union Mortgage Association in Las Vegas. With Consumers CU doing fewer than 10 of the loans in 2012 for less than $3 million, Murphy wanted advice in increasing the program’s scale. He turned to Jeff Olson, director of real estate services for the 115,000 member, $1.8 billion Spokane Teachers Credit Union, who is considered a longtime expert in custom construction finance for both credit unions and community banks.
The Liberty Lake, Wash.-based STCU made roughly $6 million in the loans in 2013, Olson said, adding that the credit union is revamping its marketing campaign to do more this year.
In addition to the longer timeframe to complete the loan, Olson said custom construction loans involve significantly more people and companies and requires specialized expertise.
“Where a standard mortgage loan has essentially three parties, the member, the credit union and the Realtor representing the seller, a custom construction loan can have the member, the credit union, the construction company, and one or more construction appraisal firms or individuals involved,” Olson said.
In addition, the loans can sometimes require some sort of hedging mechanism to guard against interest rate risk over the time the house is being built, which can be expensive, he added.
Next Page: A Degree of Expertise
All these different individuals and parts require some degree of management and expertise, Olson explained. For instance, credit unions doing custom construction lending need to be sure they have evaluated the most active building firms in their communities. If a member wants to use a builder that is not on their list, they need to carefully check out that builder before they start to work with the firm, he advised.
In a custom construction loan, builders will draw on the loan proceeds to finance specific aspects of the construction such as pouring the foundation.
“You need to check their credit worthiness, whether they have any liens outstanding, whether they have any necessary licenses required by their locality or state and see what the Better Business Bureau file says about them,” Olson said.
STCU keeps a list of approved builders on file. If a member applying for a custom construction loan expresses interest, the credit union will provide the list, Olson said. The disadvantage here is it might mean the credit union does not go forward with the loan.
To illustrate, Olson recalled how a member wanted STCU to finance a custom construction loan but the member’s first two builder choices had simply not met the credit union’s requirements. The member wanted the two firms because they offered very low bids for the job however, the credit union couldn’t take that risk, Olson recalled.
Another area that needs to be managed is the way the loan’s funds are disbursed, Olson explained. A standard mortgage loan tends to disburse its funds in the form of one high value check familiar to many home owners from when they bought their homes. Custom construction loans are disbursed at different times in what are called draws that are usually tied to specific accomplishments in building the house.
For example, one draw might be tied to getting the site prepared and foundation poured while another might be used for getting the house frame built or getting the brickwork done, Olson said. At each of these different phases, the credit union needs to have a relationship with a specialized appraiser who can visit the construction site to determine that the work has been done in a way that satisfies the contract and uses the materials that the builder said would be used, he added.
One of the risks that the credit union has to manage is making sure the house that will eventually be built conforms to the specifics of the construction contract included in the part of the loan that the credit union financed, Olson suggested.
Nita Haas, vice president of mortgage lending at the 8,000 member, $63 million Jeep Country Federal Credit Union in Holland, Ohio, said the cooperative is considering launching a custom construction loan program in 2015. Haas said her area had been hit hard by the Great Recession, especially within the local housing market and home building industries. The good news is both sectors are making a comeback, she noted.