Deciding to build is an exciting moment. Your home will not only be brand new, but you have the opportunity to influence every square inch of the design. If you’re financially secure enough to build, but can’t swing an existing mortgage payment plus a construction loan payment, will you ever be able to build your dream home? If you’re not paying cash, does a construction loan work differently than a traditional fixed rate, 30-year mortgage?
The answers are yes and yes.
We begin with a common sense disclaimer. This article is intended to give a basic overview of the process of financing a “new-build” home. Everyone’s experience will vary slightly and we encourage you to talk to your banker for more concrete information.
The Basics of Construction Loans
Construction loans versus mortages: Some construction loans are independent and will require you to roll them over into a new mortgage once building is done. Others are a two-in-one type of loan, which live in the “construction” arena until building is done, then automatically rollover into a mortgage after a certain period of time. For the former, beware of two sets of closing costs and other fees, since you are taking out two loans. For the latter, inquire about all your options for interest rates. Can you lock in? Is there a fee? Do you want to lock in?
What is a story loan? Most construction loans will require a full overview of what you intend to do. You can get pre-qualified before you have the full story, but once it’s time to get serious, you’ll need to be clear on: your contractor and building contract, plans, intent to live in the home or rent or sell, how long you anticipate construction will take, critical elements to achieving a certificate of occupancy, and more.
When do I have to start paying back the loan? Almost all construction loans are only valid for a certain period of time before they need to roll into a mortgage or some other functionality. Many will give the option of zero-payments until the roll-over occurs. This means that after paying initial fees, you won’t need to make a payment until the construction loan rolls over and presumably, you’re living in the house. If you opt for this, the bank will be compounding interest for every month not paid. That interest is added as principle when the construction loan rolls into a mortgage.
How much should I take out on my mortgage loan? After you’re pre-qualified, get to work selecting your builder. You or your builder will likely need to provide either a contract, a proposal, or possibly even a line item list of anticipated expenses. To that amount, coordinate with your builder to add at least 10% in contingency funds. You can hope you won’t use them, but you likely will. Costs may be incurred from unexpected challenges from the site, or from increases in materials costs, or from changes you make throughout the building process. Your banker will help with this, but it’s a good tip to always keep two ultimate figures in mind: 1) how much overall would you like to spend, and 2) how much can you afford per month when the entirety of your construction loan (fees, roll-over interest, principle, etc.) rolls over into a mortgage.
Shop around and ask questions. Every bank will have slightly different terms and expectations. Be sure to understand: the totality of fees, what happens if construction runs long or finishes early, how frequently can you pull money from the loan, will the bank pay contractors directly or will you, what the bank requires with each draw (e.g. how detailed invoices need to be), and more .
For those who haven’t been through the process, it can be intimidating at first. But all too often, buyers dismiss the dream of building new not because of lack of funds, but rather because of a lack of understanding. It’s worth a 30-minute meeting with your lender to learn if building new can be an option for you.
