How To Finance the Construction of Your Dream Home
Mike Jaghnoun | 04/19/2022
Today's competitive housing market and low interest rates have led to increased home prices. As a solution, instead of buying an existing house, you may want to build your own.
Building your dream home is an exciting time. You have the opportunity to customize a home from the ground up, choosing everything from the floor plan to the bathroom tile to the location and truly making your dream home come true!
Of course, many people who want to build a home will need a mortgage to finance the construction. Paying for home construction can be more complex than purchasing an existing house, so we're here to help you understand the process of getting a construction loan and explain the costs involved.
How to Build and Pay for Your Dream Home
Financing the cost of building a home is different from purchasing a house from the market.
The process of obtaining a mortgage for an existing home is pretty straightforward — you apply for a single loan, the home is appraised, and there's one closing date with a single set of closing costs. The process can be more complex for a residential construction loan. Alongside a mortgage, it involves financing for land, materials, and labor.
Before you commit to building and paying for your dream home, you should keep a few points in mind:
- A one-time close construction loan may help you finance the mortgage, land, and construction with one loan.
- Having a plan is essential so your lender can approve your construction plans, builder, and personal finances.
- A larger down payment is more likely to be required for a construction loan than for a traditional mortgage.
- Financing the construction of your home could require multiple loans with several rounds of fees and paperwork.
Building your dream home in your preferred location can be an excellent decision, especially if you have the savings and time to secure a construction loan. Though buying an existing home can be less time-consuming and have fewer financing requirements, when you build a custom house, you can ensure you get exactly what you want.
How to Prepare for the Builder Review
Unlike a traditional home loan, a construction loan adds a third party to the mortgage transaction. Construction loans involve the lender, borrower, Which means the contractor you choose is going to have a significant influence over getting your home done on time and within budget.
To make sure you find the right builder for your home, check their references and portfolio. Ensure the builder's specifications and plans are approved by the local building authority. Additionally, your lender may request your builder's proof of insurance, work history, blueprints, materials list, a detailed budget, specifications, and a signed construction contract with the start and finish dates.
How to Budget for New Home Construction
To budget for the construction of your dream home, you must determine how much you can comfortably afford. Setting a budget allows you to have greater control over your out-of-pocket costs.
A good rule of thumb to follow is limiting your total housing expense to 33% of your gross income. This total cost includes your insurance and taxes. Use Mortgage Center's monthly budget worksheet to get started.
After you know how much you can spend, speak with a reputable builder who's familiar with the area and can let you know what you can afford in your new home. Request quotes from several contractors. Give as many details as you can regarding timeframes, materials, ideas, and concerns. These industry professionals can either validate your choices or help you avoid costly mistakes.
You'll also want to add cushions to your expected costs. For a safety net to cover unexpected expenses, you may want to add 10% to 20% to your budget. Your builder should create a cost breakdown and a description of materials, which you'll need when applying for your construction loan.
Financial Steps to Afford a New Home Build
Even if the price of buying and building are similar, many borrowers pay more to finance a new home build than a traditional home loan. This higher cost is due to the greater risk taken on by the lender — since the home that lenders use as collateral for the loan doesn't exist yet, this translates to a greater risk for the lender.
More paperwork is also involved with a construction loan because money is disbursed to the builder at different times, and the lender needs to verify that certain stages of work have been completed. Before issuing a draw, the lender will also require lien waivers that prove the builder has paid the subcontractors.
For example, if a construction project is divided into six stages, money is released at each stage. Lenders may also allow for draws to be released depending on the percentage of the project's completion. Keep in mind that although the builder may prefer multiple draws, each one adds on to your costs due to the administrative work required.
To qualify for a construction loan and build your dream home, your lender may require a significant down payment. If you don't have the savings yet, you may be wondering how to afford a down payment for new home construction.
What Are Construction Loans?
A construction loan is a mortgage that covers the costs associated with the construction or rehabilitating of a loan, which typically offer a higher interest rate and shorter term than a conventional mortgage. The contractor receives the construction loan from the lender, not the borrower. This loan is delivered in installments as each construction milestone is achieved. After the home is built, the construction loan is either paid in full or converted to a permanent mortgage.
A construction loan generally covers the following:
- Closing costs
- Interest reserves if you want to delay interest payments
- Contingency reserves if the construction costs more than estimated
Types of Construction Loans
There are a few types of construction loans that may be available to you. Loan options for new home constructions include:
- Construction-only loans: Also referred to as a two-close construction loan, you must repay a construction-only loan when the construction of the home is complete. For a construction-only loan, the lender must deem you qualified and grant you approval. You'll be required to pay closing costs more than once since you'll need to take out a mortgage after the home is built. This loan may only be an option if you have significant savings or want to find a permanent lender during the construction phase.
- Construction-to-permanent loans: A construction-to-permanent loan is also referred to as a one-time close construction loan or a single-close construction loan. With this loan, you won't have to know how to convert a construction loan into a mortgage loan. This type of loan converts to a permanent mortgage after the construction process is complete. Choose a construction-to-permanent loan if your construction plan is straightforward and you want a predictable interest rate that locks in at closing. This loan also saves you money since there is only one closing.
- Renovation construction loans: This type of loan is specifically for homeowners who want to fund major renovations on an existing home. The cost of these renovations is included in the mortgage rather than financed after closing. The loan amount is based on the property's value after renovations and repairs. If you want to purchase a fixer-upper but lack the money for renovations, this can be a good option for you.
At Mortgage Center, we offer a one-time close construction loan. With this loan, you can build your dream home without needing to take out two loans. Once your house is built, your loan will convert to a conventional mortgage automatically, so you'll only need to close once. Additionally, you'll pay interest on your loan only during the construction phase, saving you money.
How Construction Loans Work
If you plan on obtaining a construction loan, you should understand how this type of loan works before you commit.
How New Construction Loans Work
When you're building your dream home, you need financing for the mortgage, land, and construction costs. However, borrowing money for the construction of a home can be challenging to do without collateral. Lenders want to see other qualifications from you that show you'll repay your loan. Before you secure a construction loan, your lender will conduct a thorough inspection of your finances, architectural plans, and builder.
Disbursement differs from a traditional loan. Rather than the transfer of a lump sum like a traditional loan, a construction loan is paid out in installments known as draws. Each installment comes during an important phase of the construction project, such as pouring the foundation, completing the framing, and finishing the project. Before each installment is sent to the builder, an inspection is usually required. The amount of the installment depends on the work completed.
Construction-only loans are short-term loans used to finance only the home construction and not the permanent mortgage or land. For this type of loan, you only pay interest on what you borrow. However, with construction-to-permanent loans, you can wrap the interest into the permanent financing. This scenario can be best if you're renting or paying an existing mortgage while building your new home.
How Renovation Construction Loans Work
If you've found your dream home, but it needs major renovations, you may want to choose a home renovation loan. With this loan, you can include your repair and upgrade costs in your permanent mortgage. Similar to a standard construction loan, how much you can borrow for your home renovation depends on the appraiser's estimate of your property's value after upgrades and repairs are completed.
As with a construction loan, your lender will need to approve your renovation and contractor plans, and the money is paid in installments. Financing major home renovations with a construction loan instead of a home equity line of credit (HELOC) or a personal loan means you'll typically get a longer repayment period and pay a lower interest rate.
How to Convert a Construction Loan Into a Mortgage Loan
A short-term construction loan will cover only the building costs. However, after construction is complete, you may still need to refinance your loan into a traditional mortgage. Refinancing into permanent financing allows you to have more control over your loans and shop for the lowest rates.
Start shopping for a permanent mortgage when your home build is nearing completion. Speak to lenders, compare rates, and maintain your credit score during construction. If your credit score drops, this could make it more difficult for you to get approved for a mortgage and you may face higher interest rates. Once you select a lender, apply as soon as possible to avoid delays once your new home is ready to live in.
How to Obtain a Construction Loan
As with any other home loan, there are requirements to qualify for a construction loan, but these requirements tend to be more stringent due to the lack of collateral. These requirements include a down payment, a minimum credit score, and a debt-to-income ratio that varies from lender to lender.
To determine your eligibility for a construction loan, your lender will review the following factors:
- Down payment: Most lenders require a sizeable down payment for new construction, so you may need to prove you have the funds in a savings or checking account. For major renovation projects, a renovation loan may require a smaller down payment.
- Credit score: Most lenders require that borrowers have a good credit score to qualify for a construction loan. The higher your credit score, the better your odds may be for qualifying for a construction loan.
- Repayment plan: The lender may want to know how you plan on repaying a construction-only loan, such as whether you'll be refinancing when the construction process is complete or paying the balance in cash.
- Debt-to-income ratio: A lender will also consider how much debt you have compared to your income. The lower your debt-to-income ratio, the better.
Keep in mind that not every lender offers construction loans, so when you're looking for a lender, you'll first need to narrow down your search to lenders that do. Compare the terms and rates from different lenders and get prequalified before you make your blueprints. You want to choose a lender that can guide you through every step of the process with ease and minimal frustration.
How Long Does It Take to Build a House?
While building a home takes an average of six months, the length of the process can vary depending on the builder, weather conditions, complexity of the project, and your location. For example, a small home built on less than an acre of land may take just four months, while a large home on five acres may take up to a year to complete.
Construction times also tend to be longer in certain regions. Constructing a new home in the Northeast is more likely to take 13 months or longer than any other region of the United States. Delays can be caused by permitting and your municipality, which may require code inspections, approvals, and permits throughout construction. That's why it's essential to choose the right builder and lender for your home.
Timeline for a Construction Loan and House Build
To plan accordingly, you should understand the timeline of securing a construction loan and completing your home build. Since building a home can be a lengthy process and there are several moving parts, you want to choose your financing option and lender with care.
If you've decided building your dream home is the right option for you, Mortgage Center can help. In just eight easy steps, you can be well on your way to building and financing your dream home:
- Assess your finances: Most lenders want to see that you have a reliable income, adequate savings, a good credit score, and a solid credit history. Be sure you have a good credit score, and if not, that you improve it before you contact lenders.
- Get pre-qualified: The length of time it takes to get a construction loan depends on how long the qualification process takes. The lender needs to approve you and your personal finances and approve your construction project and builder. To get started, take advantage of Mortgage Center's free pre-qualification that will determine how much you qualify for so you can establish a construction budget.
- Select a builder: You want to work with a builder who has a proven record of building quality homes in a neighborhood you want. That's why Mortgage Center gives you the freedom to choose a licensed builder you can rely on.
- Submit construction plans: Your builder should submit construction plans that include a cost breakdown, description of materials, timetables, and floor plans for us to evaluate.
- Wait for credit underwriting: For a construction loan, credit underwriting is similar to that of a traditional mortgage, though it may take longer to close. This is because multiple parties are involved and the underwriting is based on a subjective future value of your home.
- Close on your construction loan: With our one-time close construction loan, you'll only have one closing. This will save you time and keep you from signing more paperwork in the end.
- Draw funds: During the building process, you'll only have to pay the interest on the amount that's been advanced for construction. This will save you money and reduce your monthly payment to keep construction affordable.
- Convert to a mortgage: Once the construction process is complete, we'll appraise the value of your new home, and your construction loan will automatically convert to a traditional mortgage. Congratulations! The home of your dreams is now a reality.
Finance Your Dream Home With Mortgage Center
At Mortgage Center, we've been helping homebuyers obtain financing for their dream homes since 1990. When you become a member of Mortgage Center, you'll be supported every step of the way by a team of more than 100 caring professionals experienced in providing mortgages to borrowers.
We value honest communication, kindness, and openness to build the strongest possible relationships with our members, teammates, credit unions, and vendors. When you partner with us, we'll act with urgency to help you take advantage of invaluable opportunities.
Contact us at Mortgage Center to learn more about financing your dream home.
Mike Jaghnoun first became a licensed originator in 2014. His first-hand experience with the mortgage process allows him to give expert advice on a variety of home ownership topics. Check out his other articles or connect with Mike to begin your mortgage applications today!
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