VA One Time Close (VA OTC) Construction Loans
Christopher Shank NMLS 2562885
Well, it’s that time again! Yesterday, I had quite a few epic discussions with folks on Facebook after I shared a few details about the VA OTC product. As part of my commitment to put education first, I’ve dedicated this article to taking a lender-agnostic dive into the world of these crazy loans, with the intent of sharing what I know in the hopes that somewhere, someone will read this and use what I’ve shared for the benefit of them and their family.
That said, let’s dive in, shall we?
What is a VA loan?
As a reward for the blood, sweat and tears shed by our veterans, the VA assisted in the creation of a loan program that, in my humble (and quite biased) opinion, is the greatest on the market. The intent behind this loan was to allow veterans an affordable means to finance and get into a house and fulfill that crucial aspect of the American dream- homeownership. Active duty service to this country is not the most well-paying of careers (a fact that most vets will happily comment upon at length). To compensate for this fact, the VA loan does not require a down payment. Additionally, the VA loan manual allows sellers or other qualified third parties to cover the veteran’s closing expenses, which makes it entirely within the realm of possibility that a veteran can finance the purchase of a home with no money required at the closing table. VA loans are also special in that there is technically no minimum FICO score required to qualify, though they allow participating lenders to set their own specific requirements outside of the scope of this article. Also of interest, the VA loan program inherently accounts for a borrower’s residual income (such as VA disability), something that is quite important, given that many veterans retire with some sort of disability or retirement income.
Like all government-backed loans, the sponsoring agency is technically on the hook (at least partially), should the borrower default on their loan. To reduce this risk, the VA created a series of checks to ensure each borrower’s qualification prior to any financing. Additionally, the VA placed limitations upon the amount of financing that any one veteran can utilize at any given time. Like the FICO situation above, this particular subject is rather involved and will be touched upon in a separate article.
Now, I did say that I was biased toward this loan type, which I totally am. In fact, it was using a VA loan that I was able to purchase my first home, a house that I would not have been able to finance under any other loan program at the time. Quite frankly, it is my opinion that the average veteran homebuyer can go their entire life using VA loans and be entirely comfortable in the knowledge that they very likely got the best deal out there.
What is a VA construction loan?
Now that we’ve broad stroked the basics, it’s time to talk a little bit about construction loans. Most homebuyers today are purchasing prebuilt structures. Even those who buy brand new houses are coming to the table after the builder has put together a finished product. Sometimes, though, a buyer wants a home that is entirely their own, and they want to be responsible for building it. In these situations, the buyer will usually look into a construction loan. Now, bear in mind that I’m keeping lender agnostic on this article- in practice, different lenders will structure things their own special way. For the sake of conferring this knowledge, though, I’m going to generalize a bit.
A construction loan is designed to give a borrower access to funds with which they can use to build their home. Once this home is built, the loan morphs into your “average” homebuyer’s mortgage. Generally, construction loans are divided into three phases; the loan approval phase, the build phase, and the loan modification phase.
Loan Approval Phase: This is where you, your loan officer, your lender, and your builder come together to iron out the specifics as to your loan. Unlike the purchase of a pre-built house (where the lender can foreclose, should you fail to uphold your end of the financing agreement), a lender will take a HUGE risk when it lends you the money needed for your construction project. To that end, they want to ensure that your plan is actually viable before any money changes hands. Within this phase, you’ll work with your builder or general contractor to draw up the plans for your home, identify resource lists, draft up a building schedule, and otherwise complete all administrative requirements set by your lender. Simultaneously, you yourself will be going through an approval process, whereby the lender will be assessing your financial foundation to determine if you personally are a good risk to invest in.
Build Phase: Here’s where you actually go through the process of building your house. Depending on your lender and product, you might be able to use part of your newly-acquired finances to purchase the land with which to build your property. Usually, instead of giving you a massive lump sum with which to fund your construction, most lenders divide your financing into smaller sections, called draws, that correlate to the build schedule you identified in the previous phase. In a traditional construction loan, you would be required to make interest-only payments on the money you’ve drawn up to this point, but as the VA does not look kindly on interest-only payments, you’re most likely going to not have to make any payments on your loan until your home is built. ***HUGE ASTERISK HERE*** This is one of the sticky parts of VA construction loans. Some lenders will factor the interest only payments you would normally make against the value of the loan. I would recommend working with your loan officer and lender to clearly investigate this matter before you pull the trigger on any construction loan, as this may need to be factored into your financial plan for the build. There is a maximum time limit on this phase, with industry averages between 11 and 14 months.
Loan Modification Phase: By this point, your home has been built and found sound by inspection. Now, it’s time for you to start paying for your build. During this phase, your lender will tally up the total amount of money you’ve spent and build that into a mortgage for you to pay off for the next X years (30 years is traditional, but this is by no means a hard number). Depending upon your lender and the construction loan product, you may be able to float your rate from when you initially qualified for the loan, or you may need to finance off of new rates.
What is a OTC loan?
OTC stands for one-time close; it’s a specific type of construction loan whereby you “close” at the end of the approval phase. These loans oftentimes have features that make the loan modification phase fairly automatic and painless. Specifically, OTC loans include features such as floating rates, whereby the rate you lock into during the approval phase carries over to your rate after the loan modification phase is complete. OTC loans also have the benefit of not always requiring appraisals during the loan modification phase.
On the whole, I prefer OTC construction loans over traditional construction loans for most buyers because it offers enhanced benefits over traditional construction loans for no major cost. Do keep in mind though, that OTC loans are not for every buyer. For example, I have a client currently looking at a 18-24 month build time for one of her upcoming projects. Last time I checked, I am not aware of any lenders who will finance a OTC with that significant a build time. Additionally, VA OTC loans carry the requirements imposed on your regular VA loans, which means that purely commercial ventures (i.e. ones that you will not immediately occupy) are not candidates for that particular loan.
How can I use this loan to build wealth?
Ah, if I had a nickel for every time I was asked this yesterday… I’d have a fair number of nickels and a bit of regret for only asking for nickels. Look, it’s no secret that VA loans have been used to build real estate empires. Heck, many of my friends used the VA loan to finance their first house, and then turned that house into a rental when they used more of their VA benefits to finance a new home. According to the VA, it’s entirely possible to finance the purchase of a multi-unit dwelling (up to a quadplex) under a VA loan, so long as you intend to use it as your primary place of residence for a set amount of time. One of Clarksville’s more successful investors used this math to grow a quadplex empire using this one trick.
For those of you wanting a more fleshed out example, here goes. The average rent rate in Clarksville, TN as of this article is around $1.25/mo/sqft. By the same token, say it costs $175/sqft to build a new construction quadplex in Clarksville. In this example, let’s say that you want to build a 4,000sqft quadplex, divided into four equal 1,000sqft units. For the sake of example, let’s say that you put $0 down on this loan, your interest rate was locked in at a solid 7%, and you miraculously financed only $700,000 on this build (4,000sqft x $175/sqft). In a 30 year mortgage, you’re looking at spending a bit more than $4,600 per month on principal and interest alone. Say, for the sake of this example, that taxes and insurance run you $200/mo. In order to break even on your loan, you’re going to need to charge each tenant at least $1,200 in monthly rent.
Notice anything interesting? Clarksville’s average rent on a 1,000sqft apartment, based on market data, is $1,250- that’s higher than your minimum rent in order to break even. Given that your units will be brand new and fairly modern, it’s entirely within the realm of possibility that you could charge several hundred dollars per month above average due to these amenities. For the sake of this example, let’s say that you charge $1,600 per month to each tenant. According to your particular VA loan, you’ve got to maintain this quad as your primary residence for at least one year, which means that you’ll only have at max, three tenants paying rent to you. Going by our math in this scenario, your monthly mortgage payment could be paid entirely using rent collected from your tenants.
Let’s expand upon this thought. Now, just to reiterate, these numbers are theoretical; they are intended only to convey specific ideas and strategies. Say you find yourself with 100% VA disability, and claim around $3,800/mo in disability pay. Referencing the numbers above, you could use your disability pay and whatever regular income you have coming in to pursue other ventures, but in this example, let’s say that you put just part ($3,000)of your disability pay toward the principal of your investment. If you were to do this, by the one year anniversary of your purchase, you would have contributed just over $40,000 toward the principal of your loan (factoring in interest reduction due to extra payments toward principal). This doesn’t include any property value increases that may have hit your area.
By the end of year two, keeping this same payment schedule and retaining one of the four units as your primary residence, you can expect to have paid off around 12.5% of your loan (again, not factoring in inflation or property value increases). By the end of year three, that percentage jumps up to nearly 20%. At year four’s end, your loan is over 27% paid off. Also, 27% paid off in this instance means that you’ve got over $190,000 worth of equity in your property, not factoring any property value increases.
Here’s where things start to get interesting. with a cash-flowing property such as this example quad, it is entirely possible for you to refinance this as a DSCR loan, freeing up your VA eligibility up for another quad build. Mind you, this situation is based upon a five-year investment. Should you invest more heavily into the principal of this property, it’s entirely feasible to reach the DSCR refinance point sooner, freeing your VA eligibility up years earlier than this projection.
Disclaimer time!
One of the perks of being a loan officer is that I have the opportunity to collect stories relating to my favorite area of intellectual study; investing. That said, I have just as many stories about men and women who have come up short as I do folks who netted themselves a profit. As I stated earlier, the intent with this article (especially the example above) is simply to share ideas and concepts that can be used to build someone’s unique investing solution. To construct a rather article-appropriate metaphor, I liken my articles to the innovative design ideas you would find on Pinterest. Pretty as they may be, it’s still in your best interest to reach out to a trusted professional to run those numbers for your own situation before deciding to pull the trigger on the most expensive purchase of your life.
