Mortgage Construction Loans

Financing new home construction

Building a home is a dream for many. It means being able to live in something they helped create, with the right amount of space, the ideal configuration, and furnishings, all in a location best suited for their needs.

But financing a newly constructed home is more challenging than obtaining a mortgage on an existing home.

For starters, there is more risk to the lender because there isn’t a property to use as collateral to secure the loan. In addition, the cost of building a home can fluctuate during the time when the loan is granted to when the house is finished.

The simplest path to financing new home construction is to have the builder finance the project. Then once the house is completed, you can “buy” the property from the builder by obtaining a regular mortgage from a bank or other mortgage lender.

If this isn’t possible, the next option is to obtain a construction loan from a lender.

The basics of construction loans
A construction loan is a short-term financing option, typically lasting from six months to a year. Once construction is completed, the borrower obtains a permanent mortgage that pays off the construction loan.

Construction loans are not as widely available as standard mortgages, so you may have to shop around to find a lender willing to make the loan.

Because construction loans are higher risk that standard mortgages, banks will usually require a downpayment of at least 20 percent to 25 percent of the cost to build the home, including land acquisition. If you already own the land on which the home is to be built, you can use that as equity on the loan.

Also, lenders will require higher credit scores than what is necessary on a regular mortgage. And even with exceptional credit, the interest rate on a construction loan will be higher than the rate on a mortgage.

Gaining approval for a construction loan requires the lender to approve the construction plan, which includes the blueprints, a timetable and overall budget.

Making a budget
The budget for home construction is where many borrowers get caught off guard. There are far more costs to building than many realize. The breakdown of the cost to complete a home include:

Soft costs—These are the most overlooked expenses and include the architectural plans, building permits, and engineering. You will also need to purchase insurance to protect you against theft or damage that may occur during the construction process.

Hard costs—These are the costs that go into the actual construction, including excavation, site work, building materials, labor and contractor fees. Hard costs are usually calculated on a per-square-footage basis.

Reserves—When building something from the ground up, many unplanned expenses can arise. The cost of materials can increase during the process. Delays caused by weather can also increase the total costs. Lenders typically budget for a 5 percent to 10 percent contingency.

Closing costs—Once completed, the new home will need to be appraised, plus there will be title fees, underwriting fees, and other administrative costs.

The payment schedule
Unlike conventional mortgages, lenders will not release the entire loan amount up front. Instead, there is usually an installment schedule based on the progress of construction.

For example, the lender may release 15 percent to 20 percent of the loan amount to pay for site preparation and foundation work. The next installment would cover framing; then another installment would cover plumbing, electrical and other interior work.

Before paying an installment, the lender will send an inspector to the site to survey the progress and ensure that local building codes and regulations are being met.

Once the home has been completed, the owners have obtained a certificate of occupancy, and all contractors have been paid, the lender will roll over the balance of the construction loan into a standard mortgage.

Lenders will often combine the construction loan and mortgage into a single 30-year loan with one closing, which is referred to as construction-to-permanent financing. In this case, the loan has two parts, a one-year construction loan, and a 29-year fixed-rate loan.

The other option is to refinance the construction loan into a regular mortgage. The downside of this option is that you will have two sets of closing costs.