Question:

For some reason in the back of my mind, I believe the credit union is limited to 12 months on short-term construction loans, and if we wanted to go longer than that, we needed to make it a one-time close (or do extensions).  Is this an old rule I’m remembering?  Or could you point me to that regulation? 

Answer:

Ability to Repay

The biggest issue is that temporary loans with a loan term greater than 12 months are subject to Reg Z Ability Repay (ATR) requirements.

For ATR purposes, the regulation requires the lender to use “the maximum payment scheduled during the first five years after the date on which the first regular periodic payment will be due” when calculating the borrower’s debt-to-income ratio. In many cases, this means a balloon payment must be included in the calculation, which will make the loan unaffordable for most borrowers.

Interestingly enough (or maybe only interesting to me), the commentary to this section of Reg Z anticipates a 12-month construction loan may need to be renewed. It clearly explains a renewal of a 12 month construction loan is still exempt from ATR requirements as the initial term was 12 months:

1. Renewable temporary or “bridge” loan. Under § 1026.43(a)(3)(ii), a temporary or “bridge” loan with a term of 12 months or less is exempt from § 1026.43(c) through (f). Examples of such a loan are a loan to finance the purchase of a new dwelling where the consumer plans to sell a current dwelling within 12 months and a loan to finance the initial construction of a dwelling. Where a temporary or “bridge loan” is renewable, the loan term does not include any additional period of time that could result from a renewal provision provided that any renewal possible under the loan contract is for one year or less. For example, if a construction loan has an initial loan term of 12 months but is renewable for another 12-month loan term, the loan is exempt from § 1026.43(c) through (f) because the initial loan term is 12 months.

ARM Disclosures

In addition, if the construction loan is secured by a home that will become the principal dwelling of the borrower and the term is longer than one year, you would also need to provide ARM disclosures if the rate is variable.

Summary

Construction-only loans or the construction phase of construction-permanent loans should have terms no longer than 12 months. If you need to, you can modify the loan to extend the construction phase if necessary (the modification must be done before the loan is due).