If you’re on the swiney side of the mammalian spectrum, you may not care how your new house build gets paid for, just so long as the thing’s not made of straw or sticks. But if you walk upright and don’t need to shave from head to toe — John Fazzolari notwithstanding — then you might be interested to learn how custom home building projects get financed.
Before launching into that bit of kibble, which we promise to do, let’s have a look at what you might need to pay for in the first place.
Money for nothing
Aside from providing a subheading that brings to mind one of the great English rock songs of alltime, the 1985 hit by Dire Straits has little relavence here. What can I say, the creative juices sometimes freeze up.
Mark Knopfler, in somewhat deprecating fashion, sang about musicians achieving fame and wealth for doing what many of us perceive to be “easy work.” Unless you’ve finger-picked the neck of a Fender Strat with the kind of speed and accuracy that gets you a seat on the Queen’s Honours List, you might share the song’s perspective. In that case, well, you and I would have to agree to disagree. However, one thing that we most likely can agree on is that new home projects are dang expensive. Hey, if you have a “Sir” in front of your name, maybe you can pay cash for your next castle. But the rest of us might need a little help from the bank.
Here’s a look at what you might be borrowing money for before, during, and after your new home gets built:
Fazzolari Construction has been largely out of the land business since 2008. Most custom home builders who experienced the housing downturn are in the same boat, focusing instead on building new custom homes on client-owned dirt. This means that building a true custom home will most likely require you to purchase a lot before your dream home comes to life.
Getting a loan for land can be a simple process because the inspector and appraiser don’t have much to do. This is why your title company can close most land loans within 30 days.
Provided your bank has a land loan program, you should expect to cough up 20-25% of the purchase price as a down payment. That’s more than is required on a home loan because there is no house to sell should you default on your payments. Interest rates are usually 1-2% higher than prime, and terms are shorter — sometimes as little as one year. And just like with a home loan, as soon as you close you’ll be responsible for paying property taxes, insurance, and those irritating monthly mortgage payments.
So, you’ve got your land, a great set of engineered building plans, and a permit. Unless you’re going to come out of pocket at this point, you’ll need a way to finance the cost of construction. Depending on your lender, you’re likely to see construction loans structured as follows:
- 10-20% down payment
- 12-month term, interest-only
- Interest rates 1-2% higher than prime
Unlike land loans, construction loans are complicated because you’ll be asking an appraiser to assess the value of something that does not yet exist: your new crib. As your builder, Fazzolari Construction will provide the bank with a set of building plans, specs, a contract, and budgets so that an appraisal can be ordered. Once the appraisal is complete, the bank can determine a loan amount and down payment required. Keep in mind that if the loan amount falls short of the construction costs, you’ll be coming out of the back pocket of your Wranglers for the difference.
If you have a land loan, it will almost certainly be paid off as soon as the construction loan funds. This will end payments on the land and begin interest-only payments on construction. Generally speaking, most banks will count the equity you have in the land toward your down payment on the construction loan.
When construction loan payments are interest-only, and the interest rate is charged based on the work that has been completed, they increase as the job progresses. Much like my golf game, it starts out tolerable and gets steadily worse as you go.
Each month, the bank will send out a representative to confirm that the work we want to be paid for has actually been done. When they see that it has, they issue a “draw” to us and apply your interest rate to the total amount paid out to that point.
When your new home is complete, you will be ready to flip your construction loan to a permanent loan. You’ll have a couple of options.
One option you will have is refinancing your new home. This will pay off the remaining balance on the construction loan, and land you back in the familiar territory of a traditional mortgage. You’ll need to apply for another loan, have another appraisal done, and pay closing costs — all potentially for the third time if you had land and construction loans as well. Once approved, the going interest rate will be applied to the term you select, typically 15- or 30-years. Your lender may offer additional options.
A single appraisal and closing, both done before construction begins, make the construction-to-permanent loan an attractive option for many borrowers. You’ll normally pay interest-only during the construction phase, and the payment will automatically convert when construction is complete — usually after a 12-month construction term.
Monty, I’ll take door number one
An experienced loan professional can help you choose the right loan(s) for you to finance your custom home. When deciding how to structure your financing, consider the following:
With a construction-to-permanent loan, you will save money by appraising and closing only on the front end, before construction begins. You will also have the peace of mind of locking in an interest rate that could be higher — or lower — in a year.
Separate construction and permanent loans typically have slightly lower rates, a benefit you’d need to weigh against paying for another appraisal and closing, and another round of paperwork that will make your pitching arm feel like you threw both ends of a double-dip.