Construction Loans: How do I pay for a custom home?

Paying for a house that's being built on your land is very different from buying a new house from a builder, or even buying a custom home on the lot a builder owns. To build a custom home on your land, you'll need a construction loan. This article talks about the basics of paying for a custom home built on your land or lot.

How is a construction loan different than a regular mortgage?

A construction loan is different from a permanent loan (usually called a "mortgage") in several ways:

• -A construction loan comes from a bank, not a mortgage company;
• -A construction loan is short-term, meaning you'll pay it back in usually less than a year (more on how this works later);
• -Usually, you pay only the interest on the loan during construction, rather than paying principal plus interest (this is nice because you won't be making a traditional house payment for that period);
• -A bank will want a bigger down payment, as much as 20% of the appraised value of the home to be built.
• -A bank will want a lower debt-to-income ratio, which is simply the amount of your current debt payments divided by your income.

You'll apply for the construction loan after you've been pre-approved for a mortgage, because of the way the construction loan gets paid off. The bank wants to know that you'll be able to get the permanent loan (mortgage) when the house is done, because that permanent loan is what pays off the construction loan. 

What happens once my construction loan is approved?

Once you're approved for the construction loan, the bank will order an appraisal, which is a professional opinion of the market value of the new house you're planning to build. There are many factors that affect the appraised value, some of which are:

• -Location of the land;
• -Size of the house;
• -Amenities and features of the house;
• -Recent sales in the surrounding area.

If the appraised value ends up higher than what you're actually spending on the house, which happens frequently, the bank might actually reduce the amount of cash down payment you need. The reason is they usually use a formula to figure out how much your loan will be that looks like this:

Loan Amount = Appraised Value X 80%

As you can see, the amount you're actually paying for the house doesn't figure in this equation. So, if the appraised value is $200K, the bank will lend you $160K. If your house is only going to cost $190K, then that leaves you with $30K to come up with in cash.

After the appraisal is done, and the title to the land has been checked, you'll close on your construction loan and be ready to start building.

How do I pay the builder for my custom home as it's being built?

You'll pay your builder in installments, commonly called draws, which correspond roughly to specific phases of construction. This process varies widely. In principle, this is how it works: the builder completes a phase (let's say the foundation, under-slab plumbing, and the concrete slab); you pay a certain percentage of the total price. Each time the builder completes a phase, you pay an agreed-upon percentage of the total, until the house is 100% complete. 

Once you've paid the builder 100% of the total, you'll start the process of closing on the permanent loan, or mortgage. From the perspective of the mortgage company, this isn't a new home purchase, it is a re-financing of an existing loan (the construction loan). Basically, you're taking out a new loan that pays off the existing construction loan.

That's the process in a nutshell. For more information on financing a custom home, please check out our blog summary page on the financing topic. 

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