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Plan carefully before you build. Take the time to understand your lot, the soil, and local regulations. Next select a plan that works for you and your site. Then look at ways to finance your dream home from conception through construction.
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| | BobVila.com > Channels > Finance > All Articles > Financing New Home Construction
Financing New Home Construction
It takes equity to build a new home, which is why more and more homebuilders are using their existing homes to finance new construction.
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New home financing differs from a traditional mortgage. Equity is still required, but managing the construction loan differs depending on the financing vehicle you choose.
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Fewer first-time homeowners are buying brand new homes, according to the National Association of Home Builders (NAHB). That may be because it’s hard to finance a newly built home without a major asset to borrow against. Michael Carliner, an economist with the NAHB, adds that most homebuyers need a house for collateral when building their new home. As a result, present homeowners are responsible for most of the new home starts.
New home buyers tend to be married with children and are typically trading up for bigger and better homes that can be customized to meet their needs, according to the Economics Group at the NAHB. But to build that home, owners will need a loan. How, then, does one finance a home under construction?
Using an Existing Home for Construction Equity
Financing new home construction usually follows one of three financing avenues: a home equity loan, a construction loan, or a bridge loan.
A home equity loan is a great option for those who own their own home free and clear. Lower closing costs are a primary benefit since homeowners may not need an appraisal or a title search. With individual financing like this, the homeowner takes responsibility for paying the builder as work progresses. If the new construction costs more than the present house eventually sells for, a new, smaller mortgage is often sought when construction is completed.
A construction loan is for those have sold their house and are using the proceeds to help fund the new home. While construction is under way, these people opt to live in temporary quarters. Some may even work out an arrangement whereby they rent their sold home from the new owners until construction is complete.
A bridge loan is for homeowners who have not yet sold their present home and have a mortgage on it. With a bridge loan, the lender allows a homeowner to borrow against the present house before it is sold to “bridge” the funding for the new construction. The loan is usually equal to a percentage of the expected sale price, often 80 percent, and is good for six months. If the present house does not sell after six months, the homeowner then pays on two loans – for the present home and the new home. This is why lenders frequently apply the worst-case scenario in determining eligibility: A homeowner must qualify to pay both loans.
Construction Loans
The most common financing vehicle for new home construction is a construction loan. The application process is the same as for a mortgage. It requires a down payment, that typically equals 20 percent. Borrowers must provide proof-of-earnings statements, verification of employment, debts not noted on credit reports, and other information.
Lenders offer a variety of construction loan options that can vary by region and even by borrower, based on duration of employment and credit score. Options also vary depending on whether the loan can be approved locally, which may provide some leniency, or whether it is dependent on computer underwriting, which works by a set of standards.
Financing a Construction Loan
Two typical financing avenues are an adjustable rate mortgage (ARM) and a “construction to permanent” loan. Both only often require interest payments for six months. ARMs are amortized—broken into payments that cover principal and interest—over 30 years and are typically offered for one, three, or five years. Many borrowers choose a one-year ARM with the intention of rolling the loan into a fixed-rate mortgage, subject to rates at that time. A construction to permanent loan applies for six months or until construction is completed. At that time, the loan is converted into the desired mortgage vehicle, ARM or fixed rate. In both options, the final interest rate typically cannot be locked in until the home is within 30 to 60 days of completion, says Scott Sauer, a Wisconsin credit union president and longtime mortgage lender.
Borrowers may have to pay closing costs twice with the construction to permanent option, depending on whether the loan remains in-house or is sold to a secondary mortgage market. Borrowers should verify how the loan and closing costs will be handled before deciding where to get a loan.
Managing a Construction Loan
When applying for a construction loan, the lender requires builder-supplied blueprints, specifications, and cost breakdowns. Borrowers will also have to supply information about plumbing fixtures, custom cabinetry, and flooring, says Sauer. The lender then gives the information to an appraiser who determines the fair market value for the house if built according to specifications and on a given piece of land. The appraisal determines the loan amount.
A construction loan is set up like a line of credit with a set limit, but only the lender can make withdrawals. As work progresses on the new home, the builder submits bills to the lending institution, which acts as money manager for the project. The lender may pay construction bills on a monthly basis or at predetermined intervals such as after excavation or basement completion. The lender or its representative will visit the property to verify the work and items billed. Money is then drawn from the account and disbursed. The borrower only pays the interest accrued on the amounts drawn.
Converting to a Home Mortgage
Once construction and the final walk-through with the builder are complete, the lender will need documents to show the house is ready for a mortgage. A satisfactory final inspection by the local building inspector, a completion certificate from the appraiser, completion and signing of all lien waivers, and final endorsement from the title company that provides a clean title to the property are standard. If there are overages due to add-ons or upgrades, the terms for the final loan may need to be redone. Borrowers often work around this by paying private mortgage insurance, if their down payment is less than 20 percent, or arranging for a second mortgage.
Turnkey Loans
Builders who produce many homes a year sometimes offer “turnkey construction” on lots they own. “This arrangement functions more like the standard purchase of an existing home,” says Jim Olds, a realtor and exclusive marketing representative for Best Builders in Menasha, Wis. “The pre-approved buyer contracts to have a specific home built. The home is built as a contract home but without the draws. Instead, the builder finances the project and the buyer only has to obtain the final mortgage when the house is completed. Through the contract, the buyer will know exactly what the final cost will be—if he or she has not made changes along the way.”
Olds says it is important that the buyer understand the build contract. Some contracts may be written to allow for extra charges for difficult excavations or if there are price increases for materials.
“The turnkey option offers advantages to the builder because there is no need to wait for verifications and draws and there is less paperwork,” says Olds. On the buyer’s side, there is only one closing, not two.
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Interest-Only Options
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Will and Laura have qualified for a 4 percent interest-only six-month construction loan on their dream house. They sold their former home for $150,000 and used the $50,000 equity as the 20 percent down payment on the $250,000 loan. Their first payment, for interest only on the $44,000 draw, after excavation and the pouring of the basement, was $144.66. Their second interest-only payment, for an additional $72,000 draw, was $381.37 and the principal balance grew to $116,000. When construction was completed and all the draws were made, the principal balance was $200,000 because they only paid the interest on money used and not on the principal. With their dream house complete, they looked at a 15-year 4.75 percent mortgage but the $1,555 monthly payment was too high since they would still have to pay real estate taxes and insurance. They opted for a 25-year mortgage at 5.20 percent with an easier monthly payment of $1,193.
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Text by Maureen Blaney Flietner
Copyright BobVila.com © 2005
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