The first step when considering building or buying a new home is to search for financing. There are a number of lenders anxious to get your business. However, a mortgage, which is what you would apply for if you were buying an existing house, is different from a construction loan. A construction loan is a loan that is acquired if you plan to have a home built.
It is always a good idea to begin interviewing banks as you want to be sure that you have more than one lender you are speaking to. This allows you to shop for the most competitive rate for your construction loan. We will revisit the notion of financing a couple of times throughout this blog series but as you begin to consider build vs. buy it is important to understand the following:
1. How much money do you have to put down on a project?
2. How large of a loan can you qualify for?
3. What do you want to spend?
4. Do kind of a loan product do you want?
Let’s examine each point individually.
How much money do you have to put down on a project?
If you are planning to build a home, a lender will generally require 20% – 25% down. This can be in the form of equity or cash. Let me explain. If you decide that your budget for a new home is $600,000, you will need $120,000 in cash or perhaps you use a lot that you own as equity. The bank will use this as security during the course of the loan.
How large of a loan can you qualify for?
While you might not proceed securing a loan with a lender until you have your lot selected and you have a builder identified, it is a good idea to understand how much you can qualify for. A discussion with a lender will give you this information before going through the process of qualifying so you have a rough idea of how to establish your budget. Once you have selected a lender, then go through the application and qualification process. Remember, once you complete an application the lender has your permission to run a credit check. You should protect your credit by minimizing the number of credit checks run annually so be cautious about who you give permission to. Your credit can be negatively impacted the more times one runs a credit check.
What do you want to spend?
In other words, what’s your budget? Being able to qualify for a specific size of a loan does not necessary mean that you want to spend that much. Consider where you are in your career, how long you want to be paying on a home and what you feel comfortable paying each month. Those are all factors that go into how much you want to spend. You do need to be reasonable, however. Depending upon your market, cost of materials and labor to build a house can vary significantly city by city. It is very unlikely that you will be able to build a home of the same size for the same money that you did 10 years ago unless the location has experienced a significant economic decline. Cost of materials are increasing between 5% – 10% per year for any given item. That said, it may be that you are at a point in your life where you want to downsize and you can get exactly what you need in this new home at a price that is reasonable.
What kind of a loan product do you want?
Fortunately, today there are many lenders competing for your business. Additionally, there are a number of new products out there to choose from. In general, there are two of significance. First, there is a traditional construction loan that is generally secured for one year and has an interest rate that is tied to the prime lending rate. These can be anywhere from 3/4 – 2 points above price. You will have closing fees and all of the other fees similar to that of a mortgage. Remember, this is a short term loan that is generally one year in length; though for larger projects we have seen them up to 18 months. Because it is one year in length, you should also have a mortgage company lined up, in advance, that will be providing your longer term mortgage if you need it. I mention this because it may be that you already have a buyer for your current home and you plan to use the sale of this to pay the principle on the construction loan so you do not need a mortgage. It is important to discuss these scenarios with your lender and your builder.
Your second option is a construction loan that rolls into a long term mortgage. These products are newer but more and more lenders are offering them to be competitive. These are wonderful as they are often a “one time close”. However, they sometimes offer a higher interest rate on the mortgage than what you could get elsewhere. Again, it pays to shop around.
I hope you found this segment useful. The next topic will be some tips about selecting a builder.