What I Can Afford In A New House? Where To Get The Money?
Obtaining Construction Financing For Your Dream Home
On the surface getting construction financing before you have plans or a builder sounds counter intuitive. However, we have worked with a few homeowners that wait to get financing after they have fallen in love and are mentally living in their new home. Only to find out that they cannot obtain financing for enough to get the home of their dreams. However, sometime it is the difficulties of construction financing over a permanent mortgage. Next, let’s look at some definitions below.
- Permanent loan – Typically called a mortgage, which is the type of loan when you buy a house. Furthermore, the payments are typically for 15, 20, or 30 years. Although, you can’t use this kind of loan to build a new homes near me. However, you will use this loan once your house is finished. You typically get a permanent loan from a mortgage company, not a bank. Yes, some banks have mortgage companies, but they’re different entities. Likewise, permanent loans include principal and interest payments, and the loan payment may also include home insurance and real estate taxes.
- Construction loan – Temporary loan, sometimes called interim loan that comes from a bank. Also, it has a very short term, usually nine to twelve months, at which time it must be repaid in full. Therefore, when your new house is finished, you close on a permanent loan that pays off the construction loan. Once that’s done, you start making monthly payments just like if you had bought the house and lot together from a builder.
How a Construction Loan Works
Gather all those documents that describe your financial situation in great detail. These would include W-2s, tax returns, bank statements, etc. Next, the loan officer will turn it all over to an underwriter. No matter what the loan officer has told you, whatever bright promises he or she has made, the underwriter is the one who will put all your financial documents under scrutiny to determine whether or not you are qualified to borrow the money.
Your income. If you’re applying as a married couple, it will be your combined incomes.
Your debt-to-income ratio, which is simply your monthly debt payments divided by your monthly gross income. In general, your debt-to-income ratio must be 43% or less.
Other Factors For Construction Loan Approval
As part of the approval process, the banker will tell you how much money they’ll lend you. However, this is subject to the appraised value of the house you’re going to build. Also, your permanent loan factors into the construction loan approval, as the bank wants to make sure they will get paid back when you get your permanent loan. Therefore, to do that, they’ll likely make sure you qualify for the construction loan now and check that you’ll be able to qualify six to nine months from now for a permanent loan. Finally, you’re approved (doesn’t it feel good to have a bank “approve” of you?), the next step of the process includes two things:
The house you’ll be building, and
The land you’ll be building on.
At this point, you probably don’t know exactly what house you’ll be building. Which is good because you just found out from the bank the maximum amount of money you can borrow, which might end up being different than the actual amount you borrow.
Loan to Value (LTV)
The next step to take is to define the house you’ll be building. Although my experience building and designing a few hundred homes has proven that the most cost-effective, most time-efficient, and least frustrating way to do this is find a design builder. Find one you trust and get along well with and commit to their process of designing (or selecting) a house plan that fits your needs. Your budget will determine how many of your needs and wants fit in the plan.
Once you’ve defined the house plan that fulfills your dream and fits your budget, you’ll submit the plans, specifications, and building contract to your banker. Next, the banker will hire an appraiser who will complete an appraisal report, which is basically an expert opinion of the market value of your to-be-completed house.
Construction loan closing
Three things need to come together so you can close on your construction loan, which means you sign papers and start getting money to build.
- Clean title on your land;
- Appraisal report; and
- Final underwriting.
We discuss more about land title in our “From bare land to dream home” article. At closing, you will sign a mind-numbing stack of documents for the bank and a few for the title company. Essentially it all boils down to that you’re going to borrow a certain amount of money from the bank, they’re going to charge you interest, and you’re going to pay it all back on a certain schedule.
Now that you’ve closed on the construction loan, you’ll probably make a deposit to the builder, which serves two purposes.
It demonstrates good faith, which means you’re serious and will pay the builder as promised.
It gives the builder a little money to start committing subcontractors to begin work.
As work progresses, you’ll pay the builder according to a payment schedule defined in the construction contract. Here’s an example of what that might look like:
- Pay 5% at closing, of the construction loan;
- 20% at the completion of pouring the slab and foundation;
- 15% at the completion of framing
- Then, 20% at the completion of drying-in, which includes framing, installation of windows and exterior doors, and roofing;
- And so forth until all payments are made.
Basically, at predefined phases of construction, you’ll pay the builder predefined amounts of money until 100% of the work is complete and 100% of the contract amount is paid to the builder. Once that’s done, you’ll set up a closing for your permanent loan, more commonly known as a mortgage. Furthermore, this permanent loan pays off the construction loan, and then you start making your monthly payments.
Paying with Cash
If you are paying to build your custom home with cash, you’ll need to take some precautions. Be sure to protect your budget and time the outflows of cash properly. However, you’ll also need a safe method to prove to your builder that you have the cash available. Therefore you’ll want to keep your cash in a place that’s comfortable for both you and the builder so that you’re both confident it will be there when it’s time to pay the construction bills.