New construction loans are different than conventional mortgages. Getting a loan to build a house requires more time and patience than obtaining a mortgage loan, and you’ll have to provide considerable documentation to the lender. Borrowing the money to build a house is worth the effort because, in the end, you’ll have your dream home.
Financing to Build a Home
When you obtain a new construction loan, you aren’t receiving a 15-or-30 year mortgage. Instead, the loan is generally repaid within a year of the date of issuance. You also won’t enjoy a fixed interest rate since the construction loan rates are variable, moving up and down according to the prime rate. Whatever the interest rates, they will prove higher than those on conventional mortgages. You must also lay out a considerable down payment, usually between 20-and-30 percent of the overall price. However, most borrowers pay only the interest on the construction loan each month until the building is completed. After completion, you start paying the lender for the bulk cost amounts.
Before searching for financing, choose your builder. You may want to opt for a lender that often works with your builder since finding a lender for a construction loan is not as easy as finding a lender for a standard mortgage. Just make sure the builder’s lender offers competitive rates. You may find better rates via a credit union or savings and loan association rather than a bank per se. However, if the lender is not familiar with the builder, expect them to require the contractor to provide their work history and a variety of bank and other references. Just make sure you choose a lender who has a great deal of experience with construction loans, as the building process is often complicated.
In addition, due to the inherent risk of construction loans, you must have stellar credit and a low debt-to-income ratio. With a traditional mortgage, if a borrower defaults on the loan, the lender can seize it. That’s not realistic if a borrower defaults on a half-finished construction project.
Getting a Loan for Land
If you’re purchasing new construction in a development, that’s one thing. If you’re building your house on your own lot outside of a subdivision, that’s another. Along with construction financing, you’ll have to obtain a loan for the land purchase. A land loan typically involves much higher interest payments than mortgage loans, along with a sizable down payment. That’s because land loans are just as risky for lenders as construction loans. If a person experiences financial problems, they’ll do what they can to keep a roof over their heads. Walking away from raw land is a much easier decision. If the lender does foreclose on the land, it may take quite a while to sell it. One caveat: Avoid buying land if you don’t intend to build on the property anytime soon. That’s because the interest rate on a raw land loan will soar, and you may have to make a down payment as high as 50 percent.
An alternative to taking out a land loan if you find the perfect parcel but don’t intend to build for several years is using a home equity loan from your current house to buy the land. Your house serves as the collateral for the loan, and there are no down payment requirements. Just remember that under the 2017 Tax Cuts and Jobs Act, you can no longer deduct the interest from your home equity loan if using it for this purpose. If you do pursue a land loan, look for local lenders. They are familiar with the area and know the land values.
If you don’t need a land loan because you already own the property, that’s a big advantage. You can use the equity in your land for your building loan, possibly covering your down payment.
The Loan Story
When you apply for your loan, you must show your lender what is known in the business as “the loan story.” It’s the soup to nuts plan for your home’s construction, created by your builder. Along with the specific building plans, you must provide the construction contract and the project’s cost estimate. The information you must present to the lender includes the materials used in the construction of the home, the size of the house and which contractors will do the work. The loan itself will cover not only the construction costs but permits, fees and architectural plans.
The builder breaks down the various costs to build the house so that specific costs are segmented into work periods. The lender does not give the entire amount of the loan away at one go. Instead, the builder receives the money at specific intervals as construction is completed and the lender verifies the work is done. Generally, the builder is compensated on a monthly basis as the project moves along. Payment is received after the foundation is poured, the framing is erected, and other construction targets are met. The lender sends out an inspector to confirm the work is done before the money changes hands. The money is disbursed by the lender directly to the builder, not to the borrower.
Keep in mind that construction costs often rise substantially above budget, a situation of which the lender is well aware. You’ll have to demonstrate to the lender that you have sufficient funds to handle unexpected expenses. The construction loan may include such contingency costs in the form of reserves. Since you are paying a high interest rate on these reserves, it’s possible the lender will waive them if they determine you have sufficient funds to handle the expenses as they arise.
If you own your current home, you may qualify for a bridge loan, another method of obtaining new construction financing. These loans are also known as interim financing loans, but the term “bridge” is apropos because you are bridging the gap between the time you sell your current home and purchase your new property. Expect to pay 2 percent above the current fixed rates for mortgages, along with significant closing costs. While a bridge loan is costly, it does relieve you of the need to sell your present home before your new home is complete, avoiding the need to rent a house temporarily or find other living accommodations. A bridge loan is short-term, so you’re not paying that extra interest for very long. On the other hand, if moving more than once isn’t too much of an issue, you can avoid the need for a bridge loan by selling your current home and using the proceeds as equity in your new construction.
Rolling Over Your Construction Loan
Some lenders will let you roll your construction loan into your mortgage loan once construction is completed. This means you only have to pay for one set of closing costs, which can run between 2-and-5 percent of the overall purchase price. Such rollovers are known as construction to permanent loans, with interest rates locked in at closing. Another option is obtaining an interest-only loan for the construction process, and upon completion of your house, refinancing into a conventional 15- or 30-year mortgage.
A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including PocketSense, Zack's, Financial Advisor, nj.com, LegalZoom and The Nest.