Finance Your New Construction Home

How Constructions Loans Work

A construction loan allows you to build your own home rather than purchasing an existing home. The plus side is that you can design your new house to fit your exact needs on a piece of land you chose on your own. The downside is that getting a construction loan is more complicated than a traditional home loan and not all lenders are willing to do them.

Here’s exactly what you can expect throughout the process to make it as smooth as possible. With some upfront research and preparation, you’ll be ready for any potential bumps in the road before they even occur.

Approval

When you opt for a construction loan, the approval process doesn’t just involve you, it also involves the team working on your new home. You’ll need to supply your lender information on the general contractor and maybe even subcontractors. The lender will then likely run a credit check on those parties, as well as checking to make sure they’re appropriately licensed for the job. They may also check out the house plans to review the size, building materials, and other details of your floor plan.

As a borrower, you’ll need to undergo a personal credit check yourself and also have substantial savings. That’s because you’ll not only need to make payments on your new home as it’s being built, you’ll also need to keep up with your current rent or mortgage payments if you’re not staying with family while you build.

Check on these financials requirements in advance to make sure you understand the full involvement that comes with a construction loan. There are options for bad credit borrowers with limited cash on hand for a down payment, but those are harder to come by. Start the process early and talk to a lender that specializes in construction lending as soon as possible before you even start working with a builder. You don’t want to spend money on consulting fees with a builder and then realize that the construction process doesn’t work for your financial situation.

Inspection Process

The inspection process with a new construction home is a much more in-depth one than with a normal home purchase. When you buy an existing home, you go through one inspection and then finalize negotiations with the seller to address any concerns before you go to closing.

The inspection process with a construction loan has several steps, so be prepared before you even get started building.

Since the lender is financing a project as it’s being completed, inspections will be done at specific intervals to ensure the work is being done and is on schedule. The lender releases payments as different milestones are completed. Examples of milestones include:

• Loan closing
• Lot grading
• Framing

The builder then receives a payment that is drawn on the loan in order to have the funds to keep moving forward with the project. An inspector comes to review the progress on behalf of the lender and report back to make sure everything is getting done correctly. This role in project management protects both the lender and you as the borrower since the building company knows they won’t get paid until they complete certain stages of the construction.

Financials

A construction loan is structured differently than a regular home loan so don’t be alarmed if you see higher interest rates. In fact, you can definitely expect to see higher rates because of the additional risk involved for the lender and because of those extra steps necessary to complete the inspection process.

You’re also likely to see variable interest rates that can change if the prime rate increases or decreases during your term. It’s possible, although not always common, to find a lender willing to offer a fixed rate construction loan.

The good news is that whatever option you find, the construction loan won’t last as long as a traditional mortgage would. In fact, the most common term is just one year, and then you would refinance to a traditional 15- or 30-year mortgage. Plus, you’ll only pay interest on the amount of cash that is disbursed to your contractor.

The final financial consideration is your down payment. Working with a construction loan lender will very likely result in a higher down payment requirement. If you already own your land, you may be able to put down just 10%, otherwise you’ll likely need a 20% down payment.

You can also make a higher down payment than requested in order to save on your interest rate. If you’re able to make the financial commitment, it may be worth the long-term savings to lower your interest rate, even if by just a fraction of a point. Look into how long it would take you to make up the extra savings and see if it’s worth parting with that extra cash up front.

Closing

Once the construction of your home is complete, your construction loan will convert to a regular mortgage. You don’t have to worry about going through another approval process; that is done as part of the construction loan approval. You also won’t face any new closing costs as you switch from construction to regular mortgage. The new payments, however, do include both interest and principal payments, plus other costs like real estate taxes and homeowner’s insurance.

Don’t forget to plan for unexpected hurdles throughout the construction process. A healthy budget padding can come in handy more often than not.

If you’ve ever worked on a large home project before, you know that it’s rarely a straight line from start to finish. This is especially true when you take on a project as large as a new home. Your schedule can get slowed down from any number of issues, such as:

• Bad weather
• Unreliable subcontractors
• Slow lead time on building materials

Even the best general contractor can’t control these issues, so do be prepared for adjustments to your completion date. But if you’re willing to take the risk and have the ability to have a financial buffer, building your own home comes with a host of benefits.

Frequently Asked Questions

by Lauren Ward

Personal Finance Writer

Lauren Ward is a personal finance writer with nearly ten years of experience covering topics like loans, credit, and real estate. She lives in Virginia with her husband and three children.