Texas has a well-established history of protecting homestead property from creditor claims. Woven into the Texas Constitution is a declaration that homestead property is protected from forced sale for the payment of all debts except for in a few instances, making Texas one of the most protective homestead states in the United States. See Tex. Const. Art. XVI, Section 50(a).
This article examines the laws, loan products, and legal documents lenders encounter when originating Texas construction and home improvement loans in the residential mortgage lending market.
Legal Authority for Texas Construction and Home Improvement Loans
Article XVI, Section 50(a)(5) of the Texas Constitution deems construction and home improvement liens to be permissible encumbrances upon Texas homestead property if certain requirements are met. Specifically, this provision provides that a lender may impose a valid lien upon Texas homestead property for work and material used in constructing improvements, or used in repairing or renovating existing improvements, if:
Construction Loan Products in the Single-Family Residential Market
Construction loan products are available for conventional, FHA, VA, or USDA loans. While not all investors or insurers may offer all products, below are descriptions of construction loan products frequently found across the single-family residential market.
Interim Construction Loans
Interim construction loans finance the acquisition and development of real property. The standard interim construction loan has a short-term balloon note that typically matures soon after construction is complete. Before the balloon payment is due, most borrowers will apply for a construction-to-permanent loan that refinances the initial construction loan into a longer-term commitment, usually with a 30-year amortization period and fixed monthly payments.
One-Time Close Loans
A one-time close loan is the combination of a construction loan and a permanent loan. It is one loan with two phases and one closing. The first phase of a one-time close loan is called the construction phase, and the second phase is called the permanent phase. In accordance with the provisions contained in the loan documents, a one-time close loan rolls over from the construction phase terms to the permanent phase terms upon a specified completion date.
The construction phase of a one-time close loan is typically the interest-only period of the loan. Construction phase interest rates can be different from permanent phase interest rates depending upon a lender’s program parameters. Loan proceeds are disbursed in stages as construction progresses. Interest accrues on the outstanding principal balance and is generally paid monthly in arrears.
After construction is complete, the loan converts into the permanent phase and becomes a permanent mortgage, usually with a 30-year amortization period and fixed monthly payments.
Home Improvement Loans
Home improvement loans finance real property renovation or repairs. Some of the most recognizable home improvement loan products are conventional home remodel loans (Fannie Mae calls them “Homestyle” loans) and FHA 203(k) loans.
Texas Construction Loan Closing Documentation
Texas construction loan documents must meet certain constitutional, statutory, and administrative legal requirements. Failure to obtain the appropriate documentation can result in the failure to secure a valid lien for construction funds advanced by the lender. As a result, construction loan packages are customized by adding construction-specific provisions to standard forms, like closing instructions, and by including state-specific construction forms and disclosures. In this section, we will focus on the most common construction forms in Texas packages.
Mechanic’s Lien Note and Contract
These documents are required only in Texas for construction on homestead property. Together they create a mechanic’s lien in favor of the contractor, which is transferred to and renewed and extended by the lender. The note amount is for construction costs agreed to between the owner and the contractor, and the mechanic’s lien contract sets forth the rights and obligations of both parties. For the lien to be valid, both documents must be signed before any work is performed or any materials are delivered. For home improvement loans, the mechanic’s lien contract will include the right of rescission set forth in Article XVI § 50(a)(5)(C) of the Texas Constitution.
Transfer of Lien
This document operates to transfer the mechanic’s lien note and contract from the contractor to the lender. The lender is able to step into the shoes of the contractor and obtain the lien priority of the contractor’s mechanic’s lien to secure any funds the lender advances for the construction project.
Made between the borrower and the lender, the loan agreement sets forth the warranties, terms, and conditions that apply during construction. It sets forth the borrower’s obligations to the lender and the conditions precedent to final approval of project completion and final payment to the general contractor.
In addition to the documents referenced above, interim construction loan document packages may include:
There are several states with forms that are either required or are prudent to use during the construction period. Texas protections for materialmen and subcontractors are rooted in Texas common and statutory law and consistently reinforced by Texas courts. As a result, a Texas package could include an affidavit of commencement, affidavit of completion, lien releases, all bills paid affidavit, and other forms to be signed by the applicable parties. Texas law also requires the contractor to make certain disclosures to the homestead owner before the construction loan closes (See Tex. Prop. Code §§ 53.255 and 53.256), and the closing package may also include some acknowledgment from the owner that these requirements were met.
One-time close packages include both construction and permanent phase documents. In addition to all of the documents above, one-time close loan packages would also include:
Allonge to the Permanent Note
Attached to the permanent note, the allonge amends certain permanent note provisions for the duration of the construction period. For example, while a permanent note may provide for principal and interest payments, an allonge may provide for interest-only payments during the construction period. Using this example, when construction is complete and the permanent phase begins, the interest-only payment terms in the allonge expire and the principal and interest payment terms of the permanent note are in place.
Addendum to the Deed of Trust
Attached to the permanent deed of trust, the addendum amends certain permanent deed of trust provisions during the construction period. For example, while the permanent note may require borrower occupation of the property within 60 days after the deed of trust is signed, the addendum will provide for borrower occupation within 60 days after the construction is completed. When the permanent phase begins, the addendum expires on its own terms and the terms of the permanent deed of trust are in place.
Properly documenting a construction loan transaction requires a careful review of lender and investor guidelines, Texas requirements, and the loan program. With the right document preparation partner, lenders are able to proceed with confidence that they have a valid lien and compliant construction loan documents.
A Complex Product with an Established Framework
Over the years, construction loan volumes have risen and fallen in response to market changes or levels of interest. Some lenders have dedicated construction products. Other lenders rarely originate them or avoid the product altogether. Wherever one falls on the spectrum, lenders are able to confidently originate products backed by established laws and procedures. Thankfully, Texas provides a legal framework for the successful origination of residential construction loans.
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