A question of equity | How to calculate construction loan LVR

How does equity work?

Equity, as it relates to home loans, is the amount of the property value not being used for lending.

Consider equity as ‘skin in the game’.

If you have a 90% loan to value ratio (LVR) you have 10% equity.

For established homeowners, equity is a theoretical figure based on a valuation—so it can change. If you owe $300,000 and have a property worth $500,000, you have $200,000 in equity.

For those wanting to build a home using a construction loan, establishing equity is incredibly important.

I will take you through the different variables to consider on the way to a construction loan approval. From establishing equity using a building contract, to showing how to calculate a construction loan LVR.

LVR, equity and construction

My article on LVR meaning offers important detail around the influence of LVR in approving home loans, and setting interest rates.

Most LVR discussions centre around property already built – a construction loan LVR is different.

To demonstrate equity for a construction loan, borrowers need a lender to recognise the value of a property not yet been built. After all, the completed new home is where the equity will be—but not quite yet.

But how can a bank advance funds for a build without the value? Horse and cart.

The construction loan LVR is based on the future valuation of the finished construction project.

In simplest terms, borrowers are asking for a loan based on a bit of paper with some plans and specifications.

The solution to demonstrating equity is construction-specific valuation used by lenders called an “as-if-complete” valuation.

Why is construction loan LVR important?

In my article on LVR, I explain how lenders use LVR as a measure of risk.

Before a lender approves a construction loan, they need to understand their exposure—risk. The more equity a borrower can establish, the lower the risk they pose.

Borrower equity can be in their existing property (say land) or they can contribute equity with cash or perhaps another property they own.

Most Australian lenders consider an 80% LVR, or 20% equity from the borrower, a lower-risk loan. Construction is no different. Much like home loans, construction loans can be financed up to 95% LVR, requiring only 5% equity—but not at all lenders.

So how do lenders determine your equity position?

How do you know if you have enough equity to build?

Calculating construction loan LVR

A major factor in construction loan eligibility, is the loan to value ratio. The more equity you can demonstrate, the lower your LVR. A lender needs the following to calculate construction loan LVR.

• Establish construction amount
  Construction amount, as well as existing loans contribute to LVR.
• Construction valuation
  Usually a combination of existing land or house value plus proposed improvements.

Construction amount

In my mortgage broking experience, before borrowers enter into a contract to build, they like to understand their borrowing position. This can help in a few ways:

• Establishing borrowing capacity.
• A construction loan preapproval can be an option.
• Understand equity position for construction.
• Set a building budget.

To calculate the amount needed for construction, lenders need a building contract that covers enough detail to see the project finished. This means providing the lender with plans, specifications and build costs. Lenders will differ in what they deem a finished standard so speak to a mortgage broker about what suits your circumstances.

In Australia, the highest construction loan LVR’s are reserved for fixed price building agreements. Lenders like working with fixed price contracts as they provide a level of cost certainty. Plus, they should also offer a detailed breakdown of building stages and associated progress payment amounts.

Once you have a building contract you are one step closer to getting an as-if-complete valuation.

Construction valuation

How does the bank put a value on something that has not been built yet?

I love detail, but I value your time, so I have simplified things.

When you have a fixed price contract from your builder, the as-if-complete valuation can be ordered. The rubber hits the road.

When a bank orders an as-if-complete valuation they look at a couple of figures:

• Current property value
  This can be the value of land or an existing home you plan on improving. The more equity you can demonstrate in your existing property, the lower your construction loan LVR is likely to be. If purchasing land, your deposit will largely determine your equity position.
  
• Proposed improvements
  A fixed price building contract details plans and specifications, as well as costings for the project. There are other forms of contract but as I said. Let’s keep this simple.

An as-if-complete valuation considers both the value of proposed improvements (building contract) together with the existing property value.

To all the licensed valuers out there, I know I am over-simplifying the valuation methodology here. Borrowers – Use this explanation as guide and discuss the detail of your specific scenario with a mortgage broker.

I show you examples of how an as-if-complete valuation can be arrived at for a construction loan.

Say a borrower already owns land valued at $500,000 and wants to build a home for $400,000. Then the as-if-complete valuation is calculated like this:

The more you plan to spend on construction, the more your value can increase.

There is a point though, where a valuer may not recognise the full value of your improvements. When relying on a bank loan and valuation you also rely on your newly constructed house to be in keeping with comparable sales for that area.

You can’t go all Hollywood in….not Hollywood.

This could be a case of overcapitalisation. Either you pull back on the plans, specs and spend, or inject cash into the project if needed to reduce the construction loan LVR.

Once you have an as-if complete valuation you can work out your construction loan LVR.

How to calculate construction loan LVR

Calculating construction loan LVR is where mortgage brokers can prove hugely valuable.

Calculating your construction loan LVR is where your proposed construction loan, plus any existing lending needs to be included.

Because valuations amounts can vary, you should understand at this stage that the as-if-complete valuation influences the LVR, which can impact the following:

• Equity: Is their enough equity to qualify for a construction loan?
• Interest rates are closely related to LVR.
• Costs: Is lenders mortgage insurance payable?
• Owner contribution: Do you need to put in extra savings to bring your LVR down? Can you?
• Building costs: Do these need to be revised?

Now that you understand what is needed to calculate a construction loan LVR. Here is the formula.

Once you have an as-if-complete valuation, as well as existing loan amounts, you can calculate a construction loan LVR.

The above scenario shows how existing loans ($300,000), and the new construction loan ($400,000), together with the as-if-complete valuation ($900,000) result in a 78% LVR – and show $200,000 equity.

What if the borrower wants to spend more on their build? Say $600,000?

By increasing the construction amount, we assume it also increases the valuation amount. But look what happens to the LVR.

The LVR increases to 82%. This highlights how the construction LVR is vulnerable to change. The construction loan LVR is now over 80% which brings LMI into the picture.

What if the borrower could improve their equity position? Say they had $50,000 savings to contribute? This would reduce the over loan from $900,000 to $850,000 so:

$1,100,000 – Value
$850,000 – Loan
77% – LVR

Great. The LVR is back under 80%.

But wait – some things are out of your control. What if the land is not worth as much as you thought? And you did not have a spare $50,000 to throw at it?

Now this scenario gets interesting. We now have a 90% LVR with an equity position reduced to $100,000.

There are so many variables, that can impact a construction loan LVR. Moving parts in finance require logic, process and expert guidance. Engage with a mortgage broker early in your journey.

When do you need a construction loan?

You need a construction loan if you want to borrow for renovations of a structural nature. Think big building projects, like changing the footprint of your existing home. Lenders will have their own specific definitions around what type of projects require constructions loans.

Most of the time, construction projects should add value to your home. This is why lenders are happy to engage and work out a way to value your improvements and approve a construction loan.

Lenders and mortgage brokers will be able to advise on the specific loan for your needs.

How does a construction loan work?

A construction loan is an approved loan limit that is only drawn upon as a building project progresses through its stages. So, a lender can approve a loan limit but still retains control of these funds.

The key to a successful construction loan application is to show enough funds are available to finish the job. The funds for construction can come entirely from a loan, or a combination of cash and the construction loan. The last thing anyone wants is a half-built home and no more money—that is what reality TV shows are for.

Controlling payments to the builder is a way a lender can ensure the finished project is delivered. A borrower benefit to funds being released in agreed stages is interest costs can be smoothed out. They are only charged on the amount of the loan that has been used.

Construction loans are typically interest only until the final payment has been made where it can convert regular principal and interest payments.

Considerations for constructions loans

Over my mortgage broking career I have heard from numerous borrowers about their construction experience. Believe it or not – many borrowers had great experiences. Here are some considerations for borrowers looking to build with a construction loan.

Builder
Lenders are a great help in relation to ensuring everything is in order for a construction loan. They will help ensure all the items required for a build are crossed off prior to making funds available.

When using a builder, lenders will usually ask that they are registered and hold insurance policies for both project-specific and wider business coverage.

Delays
Borrowers should be aware loan approvals do not last forever. Lenders usually want a construction loan to begin within 12 months of approval. This may sound like a long time, but can fly by in the world of construction.

Changing costs
Changing plans along the way will often add costs to a building project. Some changes fall within borrowers control, and some do not.

Lenders approve loans based on a specific loan amount, building cost and valuation. If changes are made that increase costs, a lender is unlikely to have the loan funds available to pay any increased costs. Any extra costs over the scheduled progress payments is something borrowers should be prepared to pay for.

Land value
Land value can decrease or increase. Work closely with your mortgage broker to ensure:

• You are not disadvantaged by decreases to land value.
• You can take advantage to increases in land value that give your more equity.

I remember one scenario where I managed to rework a construction loan approval to remove LMI costs prior to commencing construction because land values had appreciated.

FAQs

How can I reduce my construction loan LVR?

Here are some measures to bring your construction loan LVR down. Reducing LVR can not only save on costs and interest rates, but can also be difference-maker for a home loan approval.

• Spend less on your build
  Be mindful that this could also reduce your valuation. Work with your lender or broker to understand if cost reductions could also reduce your LVR.
  
• Contribute savings
  If you have any savings, now might be a time to commit them to your building project. This can improve your equity and can reduce your LVR.
  
• Use another property
  If you have another property, you could be in a position to use equity from another property to help reduce your construction loan LVR.
  
• Use a guarantee
  Family guarantees can be used for construction loans too.
  
• Consider a revaluation
  If you have owned your land for a while and see nearby sales suggesting land value has appreciated, then revisiting your valuation could improve your LVR.
  
• Consider a mortgage broker
  Mortgage brokers can access more than one lender, which means there could be different policies or valuations more favourable for your scenario.

Where do I start?

In my experience as a mortgage broker, borrowers don’t know where to start. Some common questions I have heard are:

• How do I know if it is worth building?
• How much should I spend?
• How much will the bank loan me?

A mortgage broker can offer guidance here. There are useful online valuation tools to get an idea of property values.

Final word

When it comes to getting a construction loan approved, and finishing the build, the less moving parts the better.

Changes to your construction amount can change your loan amount, and your valuation—which can change your LVR.

These are some reasons why construction lending can be a challenge.

I recommend you engage a mortgage broker early in your building journey so you can work though the home loan approval process in a logical order. This can minimise chances of being blindsided by a re-valuation or increase in construction costs.