What I Learned About Mortgages When Building a Home
When my husband and I started our search for a property in 2010, we ultimately determined that building our own home was our best course of action. We quickly found a builder we liked and were ready to go. Of course, like most Americans, we had to borrow money to cover the costs of our house – and this is where the process got complicated.
As a personal finance writer, I’ve been familiar with the process of getting a mortgage for a long time. But I was still surprised to find that there is an added layer of complexity when you need a loan to build a house rather than buy a finished house. The challenges arise because you have to find the money during the building process, before your house is finished.
You can approach this problem in two different ways: you can take out a permanent construction loan or you can take out a stand-alone construction loan. We chose the second option because of some of the advantages of this approach, but it also created a lot of challenges along the way.
A permanent construction loan is the easiest solution
One of the easiest ways to finance the construction of a new home is with a permanent construction loan. This is a loan you take out to finance construction that turns into a permanent mortgage when your home is finished.
With a construction loan to permanent, you will put down 20% of the expected value of the future home and you can borrow up to 80% of the projected value of the future home when completed. When your home is complete at the end of the process, the lender converts your construction loan to a standard home loan after a home inspection.
Lenders usually allow you to pay interest only during the construction process with a permanent construction loan, which makes the payments very affordable. This can be important if you are paying rent or a mortgage on an existing home and don’t want to make large payments while your new home is being built.
The problem is, the lender takes a lot more risk with this type of loan because they promise to lend you money on a house that is not yet finished. There is no guarantee that the finished house will actually be valued at the expected amount, so you could end up owing more than the house is worth.
Due to the increased risk to the lender, the interest rates on a construction to permanent loan are generally higher than the interest rates on a typical mortgage loan, which is why we have opted against this approach. We didn’t want to get stuck with higher mortgage rates on our final loan for the many decades that we plan to be in our home.
A stand-alone construction loan is another alternative – which has some advantages
Instead of a permanent construction loan, we opted for a stand-alone construction loan when building our house.
This means that we have taken out a construction loan to finance the cost of construction. Then when the house was finished we had to get a completely separate mortgage to pay off the construction loan. The new mortgage we got at the end of the construction process became our permanent mortgage and we were able to shop for it at the time.
Although we made a 20% down payment on our construction loan, one of the advantages of this type of financing, over a construction loan to a permanent loan, is that you may qualify with a small down payment. of funds. This is important if you have an existing house that you live in and need to sell to generate money for the down payment.
The loan is also an interest-only loan during construction, just like a permanent construction loan.
However, the big difference is that the full balance of the construction mortgage is due as a lump sum payment at the end of construction. And that can be problematic because you might not be able to pay off what you owe if you can’t qualify for a permanent mortgage because the home is not worth as high as expected.
There were other risks as well, besides the possibility that the house was not worth enough so that we could get a loan at the end. Since our rate has not been locked in, it is possible that we ended up with a more expensive loan if mortgage interest rates increased while our house was being built.
We also had to pay two rounds of closing costs and fees and go through two closing processes. This was a major problem and expense, which must be taken into account when deciding which option is best.
Yet because we had planned to stay at home for the long haul and wanted more flexibility with the final loan, this option made sense to us.
Borrowing to build a house is different from borrowing to buy a house
When you borrow to build a house, there is another major difference from buying a new home.
When a house is under construction, it is obviously not yet worth the full amount you are borrowing. And, unlike buying a fully built house, you don’t have to pay for the house all at once. Instead, when you take out a construction loan, the money is distributed to the builder in stages as the house is completed.
We had five “draws”, with the builder being paid by the bank at five different times during the construction process. The first draw took place before construction began and the last was the final draw which took place at the end.
At every stage, we had to approve the release of funds before the bank provided them to the builder. The bank also sent inspectors to make sure the progress met their expectations.
The different draws – and the approval process – keep you protected because the builder doesn’t get all the money up front, and you can prevent payments from continuing until issues are resolved if issues arise. However, this requires your participation at times when it is not always convenient to visit the construction site.
You could have problems if your finished house is not rated sufficiently
There is another big problem that you might run into when getting a final loan to pay off the construction loan. The problem could arise if your home isn’t valued enough to pay off the construction loan in full.
When the bank initially approved our construction loan, they expected the finished house to be appraised at a certain value and they allowed us to borrow based on the projected future value of the finished house. However, when the time came to get a new loan to pay off our construction loan, the finished house had to be appraised by a licensed appraiser to make sure it was actually as valuable as expected.
We had to pay the cost of the appraisal when the house was completed, which was several hundred dollars. And, when we initially had our finished house appraised, she didn’t appraise as much as needed to pay off the construction loan. This can happen for many reasons including declining property values and cost overruns during the construction process.
When our house didn’t price as much as we needed, we were in a situation where we should have brought money to the table. Fortunately, we were able to approach another bank that worked with different appraisers. The second appraisal we did – which we also had to pay for – indicated that our house was worth more than enough to provide the loan we needed.
Before you build, look for construction loans
In the end, we are very happy that we built our house because it allowed us to get a house that perfectly suited our needs.
But the construction loan process was expensive and complicated, which required us to make a large down payment, spend a lot of time securing financing, and incur significant costs to pay for two closures and do multiple appraisals.
Be aware of the additional complications before deciding to build a home, and research construction loan options carefully to ensure you get the right financing for your situation.