New Custom Home Construction Loans —What They Are and How They Work?

If the perfect home that meets all your aesthetic and practical needs isn't available on the market, you can build a new one. A custom home presents an incredibly exciting opportunity that involves personalizing a new residential property to accommodate your taste and lifestyle needs. 

 

However, when considering building from the ground up but don't have the funds on hand, a traditional mortgage won't help finance that dream. Essentially, you will need to explore new custom home construction loans, what they entail, and the process to obtain one.

 

While you're likely familiar with a conventional mortgage, a construction loan differs in the sense that it's a short-term loan that's issued for a maximum of a year. For example, a secured California home construction loan typically covers the costs of a custom building rather than the purchase of an existing property.

 

This type of loan is different from a mortgage in how it is structured and how the funds are distributed. When looking at this sort of financing from the lender's point of view, a California home construction loan presents unknown risks and quite a number of variables like lack of existing collateral, the builder's cooperation, getting building permit approval, the uncertainty of a completed job on budget, time, and with superior quality, and more. 

 

This means that land and construction loans in California are somewhat harder to qualify for, and compared to conventional loans, the interest rate is significantly higher. For this reason, if you decide to go this route, it goes without saying that you'll need to work with a reputable custom home builder and ensure the project is completed well on time. 

 

So how exactly does this type of loan work? In the Forbes article "Construction Loans: What They Are And How They Work," Kiah Treece and Rachel Witkowski state that to obtain a new custom home construction loan and establish loan conditions, the qualifying applicant has to provide the lender with the location of the future home, building plans, construction timelines, and a detailed budget.

 

While mortgage financing is extended for years and distributes the full amount right up front, a construction loan is structured in a way that, once approved, the borrower can only access funds at scheduled intervals called "draws" tied to the progression of each phase of the build. For example, there might be a draw for final plans and permit approval submission, pouring of the foundation, installing drywall and framing, installing HVAC systems and plumbing, completing interior finishes, and so on. 

 

How frequently these draws are made can be negotiated upon loan approval. Before each draw, an appointed construction appraiser will need to validate expenses, confirm the completion of the key stage, and determine if everything that has been laid out is still on course. In addition, when the entire construction process comes to a close, the builder would have been paid all that was initially agreed. 

 

As far as a custom home construction loan is concerned, interest payment by the homeowner is based only on the actual amount that has been disbursed. At the end of your new build, you may be able to convert the loan into a permanent traditional mortgage or reapply for new financing to pay off the construction loan. 

Terms for New Custom Home Construction Loans

Availability

Because of its risks and variables, a large number of banks and lenders shied away from financing a custom-built home. But with the rise of the housing market and high demand for self-build, financing intended for construction only has seen the highest volume of availability.

Down Payment/LTV

As mentioned above, financing a custom-built home is more stringent and having some “skin in the game” offers a sense of assurance to lenders. This results in a typical down payment of 20% or more.

Meanwhile, the Loan-to-Value (LTV) ratio determines the relationship between the loan amount that a lender is willing to offer and the present market value of the home. Essentially, it is used to assess how much risk the lender is taking, the maximum amount you can secure, as well as the interest rate before approval.

Loan Length

Intended to cover the building process, construction loans are usually a form of short-term financing to be paid off upon completion of the building—which typically takes nine to twelve months. And after conversion to a construction-to-permanent loan, it can be extended for a longer period of fifteen to thirty years.

Amortization and payments

Since a construction loan funds in stages, interest-only payments (not principal) are made based on draws for the completion of each key stage. And once converted to a construction-to-permanent loan, payments, including principal and interest, will be made much like a conventional house mortgage.

Interest rates

While home builder financing offers some level of flexibility, it does come with a significantly bigger interest rate because there isn’t an existing property that can be used as collateral. An article by Construction Marketing Association “What You Need to Know about Construction Loans”reveals that interest rates are determined by loan size, terms, and the applicants’ creditworthiness and can change over the loan course.

Collateral

As far as construction loans are concerned, if the borrower has an asset such as land, it can be used as collateral should they fail to repay the loan.

Underwriting and processing

Upon document submission, the lender initiates the underwriting process where an analyst thoroughly evaluates all aspects of the project. This includes proforma, project plans and costs, as well as evidence of a payment plan and the risks that the loan presents. And even during the construction process, the lender will continue examining draw requests, project progress, and all other factors necessary for a successful outcome.

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Custom Home Construction Loan Types

When entering the world of new home financing, different types of construction loans are created to offer the homeowner flexibility. Below we explore 3 types: lot loans, construction loans, and mortgage-based loans.

Lot loans

In a lot loan scenario, the homeowner has found a great land to build on but does not have the funds to turn that dream into reality. A lot loan, through a bank or a lender, can be obtained for a primary or secondary residence in anticipation of building on it in the future. The loan typically ranges from two to twenty years and may require a substantial down payment. The good news is that a land loan does not require you to start building immediately. If you're in the process of getting your custom home plans together, you can still push your project out a year or so.

Construction loans

With this type of loan to build a house, the homeowner closes on financing that takes you through the construction period of a custom home—and as mentioned above, it's typically a twelve-month term and requires that you have a clear handle on the design, timeline, and budget. In an article written by Miranda Marquit for Bankrate titled "What Are construction loans and how Do They Work?" she shares with the readers that with a construction loan, the borrower has two sets of closing costs. One for the full payment of the construction loan at maturity and a second for converting to a permanent home mortgage.

Mortgage-based loans

If you were approved for a construction-to-permanent loan (also called a single close loan)when building a new home, you wouldn't need to go through another closing once the construction process concludes, reducing your overall fees. The mortgage-based loan is what homeowners typically obtain to purchase a ready-to-move-in home. For this loan's approval, you must ensure that you meet the eligibility criteria, including minimum credit score and the down payment. In addition, the interest rate is determined by the value of the finished property, the financial position of the applicant, and a few other terms.

Traditional Mortgage Loan vs. New Home Construction Loan

Much like any other financing, a new home construction loan comes with its benefits and setbacks. Here are some of its pros and cons:

Advantages

Firstly, the house finance cushion of a new construction mortgage aids many homeowners in realizing their dream home exactly how they have always envisioned. Moreover, because this is short-term financing for a new build, it offers a streamlined process tailored for your specific needs and further ensures that you have the money you need when you need it to cover the different stages of building your dream home.

And since the money is drawn in intervals, it allows you the flexibility to pay the interest of the withdrawn amount rather than the entire cost of the building. While a construction appraiser is required upon completion of each key stage, this can help keep things on course, get the job completed according to a detailed timeline, and avoid costly delays.

Disadvantages

Unlike a traditional mortgage which may take weeks to close, a construction loan, once all requirements are submitted, and terms are met, may take 7-10 business days for approval. Because of this, the loan has interest rates that run significantly higher and stiffer qualification requirements. And failure to complete construction within the agreed schedule may require a fee to extend the terms. Lastly, new custom home construction loans in California present a greater risk for the lender since there is no existing collateral, which also makes it harder for applicants to qualify for this type of house loan.

Construction Loan Requirements to Build a Custom Home

The requirements for securing a construction loan vary from a traditional mortgage. Below are the loan requirements to consider:

Credit score

As is typical with any housing loan, the lender will want to see a good to excellent credit score. Many lenders require 680 or higher, while others may up the score to at least 720. If you're planning on breaking ground on a new build, focus on getting your credit score in tip-top shape many months before to get the best financing possible.

Down-payment

Because of the risk of a short-term loan, construction loans in California require a hefty down payment. This varies on the amount you're looking to secure for your project. A lender may require you to cover 20% of the project's costs when taking out a loan, while with other lenders, you may be required as little as a 10% down payment.

Debt-to-income ratio

In simple terms, a debt-to-income (DTI) ratio that's ideal for approval demonstrates a good balance between the applicant's monthly obligations and gross monthly income. Typically, lenders require a DTI of 36% or lower—however, the borrower can still get qualified for a construction loan at a DTI of 43%.

Payment plan

In addition to the above-mentioned requirements, the specifics of how you will pay back the amount borrowed are an important component of securing a loan. Depending on the lender and terms presented, you may be required to set aside a certain amount called an interest reserve which will cover monthly payments based on the amount drawn at each stage of construction.

Builder or general contractor approval

According to an article by Kim Potter for US news, "How To Get a Home Construction Loan," she shares that the construction loan guidelines require the applicant to work with a qualified, licensed, and insured custom home contractor and builder. During the application process, the submission of documentation to confirm qualification, certification, work history and finances is required for approval.

5 Common Misconceptions and Mistakes about Custom Home Construction Loans

The idea of building a dream house is an exciting process for many homeowners. However, there tend to be misconceptions and mistakes that come into play when considering the idea of a construction loan. Below are just a few:

You don’t need to already have land

For homeowners without existing land to build on, the good news is this isn’t a requirement for securing a construction loan.

Don’t think “I’ve been approved, so the bank will take care of me no matter what“

Upon approval of finance to build a house, it's important to take into account that the loan has limits attached. Approval of funds, when needed at each building phase, does not mean frenzied and costly processes that overstep the agreed limit. Things getting out of control makes it difficult to get financed for a new home.  

Don’t go on a spending spree after getting qualified

Going on a wild spending spree should be a thought that never crosses your mind. Upon approval, redirecting funds elsewhere may push the debt-to-income ratio beyond the lender's loan limits. This dangerous financial maneuver makes approval for the mortgage needed when the construction loan comes to completion difficult.

Don’t forget to pay your other bills

Even with the approval of your construction loan, it's crucial to stay on track with the payment of your other bills. Late or missing payments can negatively have an impact on your credit score and hinder the chances of qualifying for a mortgage upon completion of your project.

Make sure you have a contingency for unexpected or unplanned expenses

Building a new home comes with additional expenses that silently creep up on you and require a way to pay them off. Some loan contracts allow for contingency provisions when financing building a home—however, being cognizant of unplanned costs and setting aside cash to cover these expenses is always an excellent idea.

How to Choose a Construction Loan Lender

A construction loan tends to be a more complex transaction than a conventional mortgage. For this reason, it's best to seek a lender with exceptional expertise in this type of house financing. Thorough research on the sort of terms they offer, what their underwriting entails, as well as the interest rates available is crucial. Lastly, collaborating with a lender that has gone through the construction financing process numerous times and has a clear understanding of what could go wrong and how it can be corrected can save you a lot of hassle.

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