Building Your Dream Home: Make it Happen with a Construction Loan

With residential real estate prices at an all-time low, most people in the market to buy a home automatically assume they can get the most for their dollar by purchasing a used home. While there are some great deals on the market for used homes right now, there are also some amazing deals for undeveloped land.

Rather than settling for someone else’s home and essentially inheriting someone else’s ‘problems’, why not build a new house exactly as you want it and exactly where you want it?

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For most people, the idea of building their dream home seems like an impossible goal to accomplish. Really, it’s a lot easier than most people think. If you have good credit and a down payment, you can accomplish your dream with a construction loan.

How Construction Loans Work

The most popular construction loan product available today is called a construction-to-permanent loan. The construction-to-permanent loan covers you from the ground up. It provides financing for the lot, financing for construction and it converts to a mortgage when the construction of the house is complete.

Just like a standard mortgage product, you can finance the land and house together, and avoid paying PMI with only 20% down. During the construction process, the buyer makes interest-only payments at a fixed interest rate. When construction is complete, the loan can be converted to a 15-year or 30-year fixed rate mortgage.

Some banks will offer interest reserve accounts to borrowers. An interest reserve account allows the borrower to avoid making interest-only payments during the construction process. The bank will figure out how much your interest-only payments will be and they will factor the total amount into your overall loan. They will deposit the funds into a separate account in which your interest payments will be made from during construction. This arrangement is perfect for borrowers that are paying rent or have existing mortgage payments to make during the construction process.

Your licensed contractor will develop a ‘release schedule’ which will outline the construction schedule on a monthly basis and illustrate the funding that will be needed each month to complete each step of construction. During construction, your contractor will receive ‘release payments’ from your bank in order to fund the project as it progresses.

Steps to Take

If a construction-to-permanent loan seems like a good fit for you, here’s what you need to do to get started:

1. Determine How Much You Can Afford

You will need to determine how much you can afford your total loan amount to be, including land. There are several loan calculators available online which serve as a great tool for preliminary investigation. Keep in mind that you will need at least 20% down to avoid paying PMI and make sure you factor in taxes and insurance.

If you know a reputable building contractor, feel free to get them involved at this point. They will be able to give you a rough idea of what size home you can get for your money, which will help you determine how much you can spend on land.

2. Find Lenders

While there are thousands of national lenders with competitive rates online, your best bet with a construction-to-permanent loan is often a local bank. Local banks tend to have a better pulse on the local market and are more flexible than national lenders.

Talk to more than one bank so you can compare loan products and rates.

If you know a reputable building contractor, find out what lenders they have worked with in the past and obtain their contact information. Most builders have relationships with lenders and can get you on the phone with the right individual quickly.

3. Obtain Pre-Approval

Once you have determined what you can afford and have identified a few banks, go through the pre-approval process with each bank. Make sure they include estimated taxes, outline your closing costs and offer you a competitive interest rate. Ask them to provide you with a pre-approval letter and a formal quote outlining the details of the loan.

4. Select a Contractor

If you haven’t already identified a contractor, select a reputable building contractor that is insured and licensed with experience building new homes. Make sure you obtain references and confirm that they have a high Better Business Bureau Rating, A+ preferred.

Work with your builder to obtain or develop architectural drawings for your new home. Have them put together a comprehensive budget outlining the total cost to build. Make sure your builder includes a water service or a well, a septic system or a public sewer connection, building permits and other incidentals.

5. Select a Piece of Land

Once you have your pricing in for your home construction, you’ll know exactly how much you have to spend on land. Select a reputable realtor to help you identify land within your budget.

Keep your builder involved in the land selection process so they can make site visits to the properties and help you identify any problems or obstacles the lot may present.

Make sure you verify that building permits can be obtained from the local municipality and that the lot has septic and well approval or that public utilities are available. Water and sewer can often make or break a budget, make sure every incidental item has been considered prior to making an offer.

Other Options

Some builders will offer to finance the entire project, allowing the homebuyer to simply make settlement when construction is complete. In most cases a builder will require an approval letter from a bank, a deposit and a legal agreement between the builder and the buyer. This is often a good option for homebuyers that want to streamline the transaction and stay out of the construction loan process.