How to finance a preconstruction condo
Preconstruction financing basics
- The mortgage doesn’t close until construction is completed and certificate of occupancy is issued.
- The long closing timeline can tie up your down payment for months or years.
- Interest rates may rise between the purchase contract signing and loan closing.
- Incorporating contingencies into the sales contract can protect your down payment.
Successfully buying a preconstruction condo requires more appetite for risk than with many other property purchases. There are great deals to be acquired — if buyers can avoid the many potential pitfalls of a project that isn’t yet built. This risk balancing also extends to financing, as getting a mortgage for a preconstruction unit is very different from financing an existing condo.
Preconstruction, also known as presale, condominiums are in buildings that are yet to be built. To ensure there is sufficient demand for a project, developers typically cannot get financing to break ground until at least 15 percent of the units are sold. Given the risk of purchasing a unit before it exists, developers often offer preconstruction units at significantly lower prices compared to existing condos in the area.
Not all preconstruction units are equal, however. As condos sell, the building’s future becomes more secure, and so prices increase for subsequent sales. Conversely, the risk of being an early buyer makes it difficult to obtain a mortgage for initial unit purchases. The more units that sell, the more financing options open up.
Financing the first 15 percent of units in a preconstruction project is difficult. Developers may have a preferred lender for the project that can extend financing at this stage, but typically these initial units are purchased with cash or with nonconforming loans. Earlier buy-in means a lower condo price, but a more expensive mortgage.
Once 30 percent of the units are sold, the project is eligible for U.S. Federal Housing Administration (FHA)-backed loans. The developer may take the steps to ensure the project meets FHA qualifications and, once approved, buyers can access the less stringent lending criteria.
After 70 percent of units are sold, conventional mortgages that conform to Fannie and Freddie standards become available. While there are more lending options, the unit purchase price likely will be much higher given the project’s stability. At this point, underwriting emphasis shifts from project risk to borrower risk. Preconstruction condo buyers typically need strong credit in the 700s and larger down payments.
Compared to getting a mortgage on an existing unit, which can close within a few weeks, finalizing a preconstruction condo loan can take years, depending on how long it takes to complete the building and for the developer to issue you the certificate of occupancy document you need to officially close the loan.
One benefit is that you may have more flexibility making your down payment. While you may need to pay up to 25 percent down, developers often allow installments over the period leading up to the building’s completion. Moreover, the value of your condo unit may appreciate during this period, particularly as the development approaches fruition.
The drawback is that you do not immediately gain anything from your money; it’s tied up in an as-yet intangible purchase. Accurately appraising a preconstruction condo is also challenging, as the estimate is based on comparable sales in the area. If the final appraisal is lower than the initial purchase price, it can make obtaining a mortgage more difficult. Ask for a mortgage contingency in your contract to protect your deposit in the event that you are not able to close a loan.
Interest rate risk
Another risk of a longer closing period is potential interest rate variability. The rate of your mortgage is determined when the loan closes, after construction is completed and you receive certificate of occupancy, not when you sign the initial contract. As such, rates may have increased since you first entered the arrangement.
Sometimes developers have a preferred lender for their projects. These lenders may lock in interest rates for a period of time to help mitigate some of this risk. To protect yourself, research this lender to make sure it has a trustworthy track record.
If you’re not comfortable working with the developer’s preferred lender, shop around to identify the loan conditions for which you qualify. Lenders may offer to lock in an interest rate if you and the project developer are good risks.