If you have very specific requirements or wishes of your dream house, building your own home can sound like a dream come true. But are you prepared for how complicated it can be? Unless you’re paying cash in advance, you’re going to have to take out a home construction loan.
Like a mortgage loan but not quite, a home construction loan is a short-term, high-interest loan that provides funding to build a residential building. This type of loan is typically around a year in term during which time the home must be completely constructed and the family to reside in it must be issued a certificate of occupancy. Unlike a personal loan or a mortgage loan that pays out the total of the borrowed money in a lump sum, when a person takes out a home construction loan, the lender pays out the money in stages as construction on the home progresses. Borrowers are usually only obligated to repay interest on funds drawn to date until the construction is completed.
Sounds simple, right? Well, this type of loan is harder to get than a regular mortgage loan. The rates are higher, too. Why is this the case? Why are home construction loans considered higher risk than regular mortgage loans? The fact is, with a traditional mortgage loan, your home acts as collateral. When you stop making payments, the bank takes your house to settle up on what you owe them. When you take out a home construction loan, well, there isn’t anything for the bank to use as collateral. The house isn’t built yet!
So how can you convince your lender that they can trust you? Typically, they will want to see a construction time table (estimated), detailed plans such as blueprints, and a realistic budget or estimate of cost. The borrower will be required to have a builder’s contract including the draw schedule of how the builder expects money from your loan to be released to them, a comprehensive budget outlining the cost or allocation of those funds for each construction item, and the timeframe in which the house is expected to be built. The more information you can give the potential lender, the better.
Once you’ve gotten approved for your home construction loan, you will be put on a draw schedule that follows the terms outlined in the builder’s contract. As the builder requests funds or they are sent out to him, the lender will send an agent on their behalf to inspect the job’s progress. This is another way the lender protects themselves – for example, if your builders state they need money to put in window treatments, but the walls aren’t even up yet… Well, something fishy is going on!
You, the borrower, will only typically be expected to make interest only payments during the time that your home is being constructed. You usually will not be asked to begin paying on the principal cost of your loan until your home construction is complete. This ensures that you can afford your current living expenses while taking on the construction loan at the same time – so you are not paying the equivalent of two mortgage payments per month. That would be difficult for anybody to handle.
What types of home loans are there? Well, for starters, there is a construction-to-permanent loan. This type of loan provides the funds to build the home and your permanent mortgage. Basically, the loan covers the cost of building a house, and the day you and your family move into that house, the loan automatically converts into a permanent mortgage. This is the usual type of home-building loan, because it means that you’ll only have one set of closing costs to pay, which saves you a ton of money in the long run. You can choose a fixed rate (monthly payments are evenly divided throughout the term of the loan and never change) or an adjustable rate loan (monthly payments can change on a pre-determined schedule based on the market rate). Your loan term on a construction-to-permanent loan will be either 15 or 30 years.
You can also get a construction only loan. This type of loan only covers the building of the house – once that is done, the home owner will then have to pay the loan in full or take our a second loan to act as a mortgage to pay off the first loan. These types of loans can be more expensive – because you’ll be completing two separate transactions and therefore there will be two sets of fees. To make it as simple as possible – in this case, you will have two completely separate loans: a loan to build the house, and a loan to act as your mortgage that pays off the loan to build the house. You must be careful with this type of loan, however, because if during the home building process your credit is negatively altered, you may not be able to qualify for the second loan that allows you to move into the house!
You can also look into owner-builder construction loans. This type of loan is for those who want to build their new home themselves and plan to act as their own builder. Most lenders will typically not allow this of most people because the home building process is so complex, but if you are a licensed builder by trade, you can probably qualify for this type of loan.
Once you’ve chosen which type of loan you want to get for your home building project, you must make sure that you qualify for it. Qualifying for a home construction loan is not too different from qualifying for a regular mortgage. The only difference may be that you need to have some additional cash reserves on hand as it can be typical that home construction projects tend to go a little over budget.
To make sure you qualify, you should…
Have Good Credit
There are strong credit requirements when it comes to building a home. Construction loans are simply considered higher risk. You will need a down payment of 20-25% as well. The exact down payment amount is determined by the cost of the land and the planned construction. If you own the land already, you can use it as equity for your construction loan. Your lender can help you with this, and will check the credit and credentials of your builder as well.
Have Stable Income
If you are a tried and true “job hopper”, you may want to settle in your current position for a while before trying to qualify for a home construction loan. The lender wants to know that your employment is all but guaranteed – so that they are comfortable that you’re likely to be able to pay your loan back because you have a job. If you have a new job every six months, who knows whether or not you’ll be making enough to pay your mortgage at this time next year?
Have a Low Debt-to-Income Ratio
Yes, everyone has bills to pay – but if you’re racking up thousands in debt on your credit cards and then not paying it off properly, well, you’re going to have a hard time qualifying for a home construction loan. Make sure that around the time you start this process, your debts are in order and at least somewhat close to being paid off.
Have a Down Payment of 20 Percent
There are a lot of down payment forgiveness programs for a person that is taking out a regular mortgage – less so the case for someone who is looking to take out a home construction loan. You must have at least 20% of the total cost of building your house on hand when you take out your loan. It shows the lender that you are serious about building a home and that you are responsible enough with money to save up so much for your home – and that likely you will be responsible when it comes to paying back your mortgage loan after the home is finished being built, too.
If you want to build a home from the ground up, know that you are looking at a more complex situation than if you were to go take out a mortgage loan for a previously existing home. You have to produce more documents (plans, blueprints, budgets, and builder’s information on top of the usual tax returns, bank statements, pay statements, etc), the loans are a little harder to qualify for, and more – but, on the up-side, you get to design the house of your dreams so that no detail is left behind. Whether this is right for your family depends entirely on your wants and needs as a family and your financial situation – your mortgage lender can assist you to prepare for any type of mortgage loan you choose to take out.