There are plenty of reasons to build your own home. The level of customization you get to have about every aspect of the building process means that you can build your home to your exact specifications and fit your own needs.
But while building your own home can be exciting, it’s not something to go into unprepared. There are a number of things that you’ll want to consider first and you’ll need to ensure that you have everything lined up and ready to roll as soon as it’s time to start building.
One of the most crucial considerations throughout the planning stages is money. How are you planning on paying for this project? Starting a project of this magnitude without the funds set aside to see it through to completion can spell disaster, even for the most well-intentioned homebuilder.
Unless you’ve saved up enough for the home building project, then you’ll need to secure funding before you start. For most people, this means taking out a construction loan. This type of loan is designed to cover the cost of construction, and in some cases, the purchase of the land. These loans generally last around 12-18 months, covering the construction time period until the home is complete and a traditional mortgage can be taken out.
A construction loan, though, can be more challenging to obtain than a traditional mortgage. This is because these loans are considered riskier, and therefore they usually have a higher interest rate than traditional loans. That’s because the home itself doesn’t exist at the time of lending, so if the borrower were to stop making payments, and the lender needs to foreclose, they would need to finish building the house first.
In this article, we’ll take a look at different types of construction loans that are available today. See what you should know if you’re thinking of building your own home.
Construction Loans: How Do They Work?
Construction loans work a little differently than regular home mortgages. Since there’s no collateral to back up a construction loan since the house hasn’t been completed yet, there’s more risk for lenders, so be prepared to go through some extra hurdles along the way. Your lender will most likely want to conduct a thorough inspection of your architectural plans, and finances. They’ll also want to assess the builder that you’re planning to use, so make sure you have your plans in place before you apply for a loan.
When it comes to a down payment, most new construction loans will require a solid 20% to 30% down payment. A renovation loan, on the other hand, usually requires less. The FHA 203(k) program allows some borrowers to qualify for a down payment that’s as low as 3.5%.
The disbursement of a construction loan is different from a traditional loan as well. Instead of a lump-sum transfer, the loan is paid out to the builder in installments throughout key stages in the building process.
Interest rates are higher than traditional loans, and it’s worth shopping around at different banks to find the best option. Keep in mind that generally, construction loans have variable interest rates.
If you’re thinking about building your own home, and wondering what type of funding is available, here’s a look at some different loan options.
Different Types of Construction Loans
First of all, there are two main options when it comes to financing a new-build construction project –custom home financing, where the buyer owns the land and the house and going through a tract home builder –where the builder owns the home during the construction process.
We’ll touch on both now:
Going Through a Tract Home Builder
In some cases, the builder may be willing to carry financing for the project. However, this is only the case for very large tract builders. This option would see the tract home builder handle the construction portion of the financing and they’d own the home throughout the building process, transferring the title to the buyer at the end. Going through a tract home builder is a good option for some buyers, but you would lose out on the flexibility that you’d have with a custom builder.
Custom Home Financing
With custom home financing, the buyer usually owns the land and the house throughout the entire building process. The builder is essentially employed by the homeowner to build the house, giving you more freedom in how the house is built. At closing, the buyer usually pays off the construction loan, or the loan becomes a traditional 15 or 30-year mortgage.
Here are some different types of custom home financing that are available today.
A Construction Only Loan
With a construction-only loan, the lender will typically offer enough money to cover the cost of the project, and the borrower will usually make interest-only payments until it’s complete. The principal balance is commonly due in full once the project is complete or one year later. The borrower can then pay the loan off, or apply for a mortgage with another lender once the project is complete.
Construction loan rates are almost always tied to the prime rate plus a margin. Additionally, they might have a higher rate than traditional mortgages. Construction-only loans can end up being costlier if you will need a permanent mortgage at the end of the construction phase since you’ll need to complete two transactions and pay two sets of fees.
A Construction-to-Permanent Loan
A construction-to-permanent loan functions essentially as a line of credit. The builder can draw from it at each stage of construction, and there are inspections at the project site before each draw. This loan usually covers the cost of the construction project and the mortgage on the completed property.
This type of loan is a single close loan, which means there’s just one approval process to go through. Once the construction is complete, you move into the home, and the loan is converted to a permanent mortgage.
A VA and FHA Construction Loan
VA and FHA construction loans are available as well. However, these loans can be hard to get approved for, and often have loan limitations that make them difficult to use.
An Owner-Builder Construction Loan
An owner-builder loan is a construction loan or construction-only loan where the borrower is also the home builder. However, most lenders will not allow the borrower to act as their own builder due to the complexity of constructing a home and experience that’s required to comply with building codes. However, if the borrower is a licensed builder by trade, then they may be approved.
Qualifying for the Loan
While every lender’s criteria will look a bit different, there are some things that most will want to see. This includes:
A Qualified Builder
First up, the lender will want to ensure that you’re working with a qualified builder, meaning a construction company or a licensed general contractor with experience building quality homes.
Detailed Build Specifications
Next, you’ll need to have detailed specifications on your plans. This should include everything from the materials that will be used –like insulation and roofing, and specifications on ceiling heights and room dimensions. Plans should be professionally drawn and to-scale.
They’ll most likely want to see the following from the builder as well:
- Project description
- Proof of Insurance
- Building license
- Banking info, a profit and loss statement
- Signed contract with buyer
- Specs that support the terms of the contract
- The job cost
- A timeline
You’ll also need to provide proof of ongoing, stable income. Proof of income includes bank statements or proof of income in the form of W2-s, or tax returns if you’re self-employed.
A Down Payment
You’ll generally need a large down payment for a new home construction loan. Most lenders want to see 20% to 25%.
A Good Credit Score
You will need a good to excellent credit score to get approved for a construction loan. Generally, a score of at least 680 or 700 is required.
A Plot of Land
Finally, you’ll need a plan for the land that you’ll be building on. If you don’t already own the property, then you’ll need to include it in the construction loan. In most cases, though, it makes sense to pay for the land upfront.
Building your own home can be rewarding, but it’s important to know what you’re in for. It requires a careful and deliberate approach, and plenty of research and documentation upfront, and along the way. If you’re planning to build your own home, it’s best to meet with a few lenders first, to see what your options for. Then find a qualified builder, and work closely with them to create an outline of your project. Finally, make sure you have enough saved up for a down payment, as in most cases, you will need at least 20% down.