Financing and Budgeting for New Home Construction
Now that you are thinking of building a home or remodeling, it is time to start looking at the numbers: how much house can you afford? If you are building, you’ll need to pay for the land and for the construction costs, which includes labor and materials.
- Take a hard look at your finances. Consider your monthly income, the equity in your current home, your savings, and any debt that you have. Determine what you can afford for monthly payments for your new home.
- Clean up your credit. Get a copy of your credit report, pay off old credit, and fix any errors. Get that credit score up. How high? The high 600s is a good goal. Banks will also look at your debt-to-income ratio, so take care of any smaller debts that you can pay off.
- Talk to your lender so you can understand what they will be looking for. After a frank discussion with the bank, you may realize that you will have to settle for less home than you wanted or consider other options. The mortgage specialist should be able to tell you what you can do to increase what you’ll be able to borrow.
- Save for a down payment. Will you be selling your current home to raise capital for this project? Talk to a realtor about your home’s current value and things you can do to get maximum value out of the equity you already have. If you are renting now, start saving cash to be put towards a construction loan.
- Be realistic. There is no “drive-through” window for home construction loans. Banks need the “story behind the build” before they will lend you money. Typically, lenders won’t approve a construction loan until they can be assured that the value of the home after construction is completed will be enough to back the mortgage. This means that you won’t walk out of the bank pre-approved. You’ll have to get a rough idea of your budget, work with your builder to plan your new home, then come back to the bank to get financing.
How do construction loans work?
Construction loans pay out as each phase of building is completed. The bank pays for the foundation when it is completed, then framing, then plumbing, and so on. That way the bank is only exposed to as much risk as there is house. Then the construction loan is refinanced into a mortgage to pay for the cost of construction and the home. There are two main types of construction loans: one-time close construction loans and two-time close construction loans.
One-time close construction loans
This type of loan wraps the mortgage on the house and land and the construction loan into one product with one approval process and one closing. They are also known as all-in-one loans or construction-to-permanent loans. One-time close construction loans are less common than they were ten to fifteen years ago, and can be hard to get in some areas. Most home owners like them because everything is in one package and they don’t have to go through two separate processes. One thing to watch for: if you go over budget during the construction process on this type of loan, you will have to take out a second loan to cover the difference.
Two-time close construction loans
This option is actually two separate loans. The first loan is a short-term loan for construction costs, and pays out for each phase of the build. Because it is short term, it generally has a lower interest rate. Once the home is built, the home’s appraised value minus the loan for construction costs becomes your equity and down payment for your mortgage. For example, if you paid $200,000 in construction costs in labor and materials and your home appraises for $275,000 when complete, you then have $75,000 in equity. Be mindful of the market with this type of loan: depending on the availability of housing and the cost of materials and labor, your home may not be worth much more than you paid to build it! You will have to pay closing costs twice with this loan, but you will also typically get better interest rates.
If you find that you won’t be able to finance your dream home, there are still options. Consider making improvements to your current home, or buying a home that needs a few updates. The good news about a remodeling project is that you only have to pay for the materials and labor to complete the project. Generally, remodeling will cause the value of your home to increase, which means that lending homeowners money for remodeling is more secure for the lender. See our article about budgeting and financing for remodeling [link] for more information.