Step 7: Financing Your New Build

While we touched on financing throughout the home build how-to, it’s worth taking another look at the financing options available to you. Building a house is a major, complicated undertaking with some unique aspects when it comes to financing. From new construction loans to builder-arranged loans, let’s explore the different types of financing packages available for your new build.

How to Determine a Home’s Affordability

Building a home is exciting — it’s also expensive, and the price can quickly escalate when you start upgrading features. You don’t want to put yourself in a position to finally get your dream home, only to struggle to make the mortgage payments. If you can’t keep up with your mortgage payments and you fall behind, your dream could turn into a nightmare.

Lenders typically suggest home buyers finance a loan that’s roughly twice their gross income. If you’re a couple earning a combined income of $200,000, that means you could afford a $400,000 mortgage. But this doesn’t factor in your financial and personal circumstances.

Add up your debts such as credit cards, student loans, car loans, childcare costs, utilities, and any other fixed expenses you pay every month. Deduct those expenses from your monthly income. Now deduct how much you spend per month on other things, like groceries, shopping, entertainment, etc. What’s left over? This is the amount that can go toward your mortgage payments and other homeownership expenses. The Homes.com mortgage calculator is a useful tool to help you factor in things like the interest rate, mortgage term, and even your location to help find the right loan amount.

When choosing your floor plan, try to find one below your max budget. Remember: home builds typically go about 20 percent over budget, so you don’t want to select a build that’s already at the top end of what you can afford.  

Saving for Your Down Payment

The down payment, the lump sum payment you’ll make when purchasing your new home, is typically about 20 percent of the home’s purchase price. However, much depends on the type of loan you’ll be getting. If you can’t come up with the full 20 percent to put down, you can apply for private mortgage insurance, or PMI. However, the bigger the down payment and the smaller the loan, the less risk your lender needs to take. This is especially important when building a house, which is inherently riskier for the lender than financing a pre-existing home.

If you haven’t quite reached your goal of 20 percent, consider opening a high-yield savings account or a money market account. Find ways to save money, such as curbing expenses, and set goals for yourself. Set an end date and determine how much money you’ll need to put into your savings account each month to reach that goal.

Increase Your Credit Score

Since construction loans are riskier than conventional loans, you’ll need excellent credit to obtain one. The lender will consider your gross income and your credit score, so before applying for a loan, check your credit score. If it seems too low, pull your credit report and look for any errors. Get these corrected before trying to apply for a loan.

Your debt-to-income ratio is also very important, so pay down your credit cards and loans as much as possible.

What to Know About Construction Loans

Construction loans cover the cost of building the house — not the house itself. This might include the land, the blueprints, permits, and labor and materials. Because there’s no house as collateral, construction loans are more difficult to get than conventional home loans. They are also short-term loans, lasting only six to 12 months. At this point, your loan will either convert into a long-term loan or it will end and you’ll have to get a traditional loan.

Construction-only loans:

This is a short-term, adjustable-rate loan you can get to fund the building of your home. After construction, you must pay the loan in full, often in the form of a balloon payment. It can also be repaid with a new, traditional mortgage. This type of loan is best for those who have access to plenty of cash, such as those selling an existing home to help fund their build.

There are risks to this type of loan. If you can’t secure financing or if your current home doesn’t sell before the final balloon payment is due, you could find yourself in a financial conundrum. If you plan to get a traditional mortgage to pay off the construction loan, you run the risk of your new house not appraising for the necessary loan amount.

Construction-to-permanent loans:

This type of loan is a little less complicated because you don’t need two loans with two closings. The construction-to-permanent loan funds the construction then converts to a traditional mortgage when your home is complete. You might be able to pay interest only during the construction phase, which makes the payments more affordable.

However, this type of loan is riskier for the lender because the house doesn’t exist yet, and there’s no guarantee it will appraise for the loan amount. Because of this, construction-to-permanent loans are more difficult to get and they might come with higher interest rates.

Builder and Developer Sponsored Financing

Some builders, especially semi-custom builders, make the home-buying process seamless by assisting buyers through the entire process, from sales, design and customizations, to financing and closing. These are usually well-known, prominent builders who are affiliated with or have wholly owned mortgage subsidiaries. They are in the same category as banks and mortgage companies and can provide financing to home buyers. Because some builders have become a one-stop shop for their clients, they are often also affiliated with title insurance and settlement services.

While many might provide great perks, including price breaks, free upgrades, or paying closing costs, there are some drawbacks. First, there’s a potential conflict of interest since the same company is financing and building the house. Since they are affiliated with one another, the lender may put the builder’s interest first. You might also end up paying a higher interest rate.

Bridge Loans

A bridge is another type of short-term loan, usually lasting six months to one year. It’s called a bridge loan because it bridges the gap between selling your current home and buying your new home. Bridge loans can be difficult to qualify for, and they often have higher interest rates than traditional loans. The lender will use the equity in your current home as collateral and advance you the cash for your down payment on your home under construction.

Progress Draw Mortgages

Progress draw mortgages are a type of construction loan that provide staggered funding. Lenders release loan installments as construction reaches various checkpoints. There are traditionally four phases. Phase one covers the costs for the plot and laying the foundation. Phase two is released when the project is 30 to 50 percent complete, phase three when it’s 50 to 70 percent complete, and phase four is the final payment.

To make sure the construction of your home is progressing smoothly and on time, your lender will send a home inspector to the property before issuing the next installment. If the inspector is unhappy with the workmanship or progress, your loan could be rescinded. A draw mortgage might limit your ability to make upgrades since the first advance sets the loan amount and it can’t be altered. Because this is a short-term loan that covers construction only, you’ll need a conventional mortgage once the build is complete.

Government Loan Programs

If you qualify, government-backed loans provide major benefits for home financing. There are two major types of government loans: FHA and VA. Here’s what to know about both:

FHA loans

Federal Housing Administration, or FHA, loans are government-backed mortgages designed to help home buyers with low to moderate incomes. The down payment is far less than a conventional loan, usually only about 3.5 percent, and they are easier to qualify for if you don’t have an excellent credit history. While a conventional loan often requires a score of 620 or above, with an FHA loan, you only need a score of at least 580 to qualify. If your score is between 500 and 579, you might still be able to get an FHA loan if you put 10 percent down.

FHA requirements vary by state, so do your research to find out what’s required in your area. If you’ve filed for bankruptcy, you’ll likely have to wait two years after declaring before you can apply for an FHA loan. If you lost your previous home to foreclosure, you’ll have to wait three years and have a clean credit history during this time frame.

VA loans

VA home loan programs are offered by the US Department of Veterans Affairs to veterans and military home buyers. These loans help veterans buy, build, and improve a home or refinance current home loans.

VA home loans are one of the most unique loan programs in the country. The incentives are substantial, including no down payment, no private mortgage insurance, better terms, and lower interest rates.

With a VA loan, the government acts as a guarantor on your mortgage. This means there’s a decreased risk for the lender so they’ll be more likely to approve loans with better terms. Nearly 90 percent of all VA-backed home loans are granted without a down payment. You’ll still need to shop around for a VA-approved lender to execute your government-backed loan.

Choose Your Lender and Your Terms

With so many financing options available, you’ll want to do your research and choose the one that best fits your needs and your financial situation. With some loans, such as VA and FHA loans, you’ll need to meet certain eligibility criteria along with finding a government-approved lender. These requirements narrow the scope of who has access to these loans and which lenders can provide them.

No matter what type of loan you choose, be sure to research your options, shop around, and compare interest rates from several lenders.