If you’re thinking about building a new home on your own land you might ask, "How much cash will I need as a down payment?"
The answer, like many in life, is "it depends.” But what does it depend on? Here are a few answers that will hopefully help you as you plan your build.
If you’re thinking about building a new home on your own land you might ask, "How much cash will I need as a down payment?"
The answer, like many in life, is "it depends.” But what does it depend on? Here are a few answers that will hopefully help you as you plan your build.
The first thing to understand is there are two kinds of loans for buying or building a house:
- A construction loan: The short-term loan from a bank you'll need to build, and
- A permanent loan: The loan you'll need once your house is complete—you probably know this type of loan as a mortgage.
PERMANENT LOANS VS. CONSTRUCTION LOANS
The permanent loan is the one we all are familiar with. You make a monthly payment to the mortgage company for 15 or 30 years (hopefully less, if you can) and, by the end of your term, you officially own your home.
However, you can't obtain a permanent loan for land and/or building, so you need what’s called a construction loan for that. While this article deals with how the cash down payment is figured, you can read more about construction loans in another post.
Lenders are different
Understanding the nuances of construction loans is important, especially since these loans are subject to different financial regulations and market conditions.
After all, you'll be borrowing money from a different type of lender for the construction loan than you will for the permanent loan.
The construction loan will come from a bank, which is different from a mortgage company. Banks are for short-term loans as opposed to the longer-term mortgage.
(Yes, many banks have a mortgage company as well—but the difference in structure makes them different entities, even though they might share a building or even a name.)
The bank will have a few different requirements than the mortgage company:
-
Debt-to-income ratio is the ratio of monthly loan payments you have divided by your monthly income. Banks typically like this ratio to be less than 43% or so, but this can vary widely depending on the bank. Keep in mind that Credit Unions also have more latitude than banks do.
- Cash down is the amount of cash the bank wants you to put into the deal before they put their own cash in.
Down payment
Next, we're going to talk about the cash you'll need for a down payment, why the bank wants that down payment, and how the bank comes up with the amount.
Banks see construction loans as riskier than permanent mortgages—mainly because they are lending the bank's money, rather than selling the loan to investors (like mortgage companies do). There's also the risk that the bank will get stuck with the construction loan if the customer doesn’t qualify for a permanent loan once the house is built.
Because of this, the bank usually wants a down payment of 20% of either:
- the cost to build
- or
- the appraised value.
If the house appraises for more than the cost to build the house, the bank will be lending you 80% of the higher amount.
Insider Tip: To potentially reduce the amount of cash you'll need, find a bank that bases their loan amount, and the cash down payment on appraised value rather than construction cost.
In either case, to figure out how much cash you will need as a down payment on your construction loan, you’ll need to know the amount the house will appraise for.
If the bank's loan amount is based on construction cost, they won't lend more than 80% of value in any case. For example, if your cost to build is $500,000 and the house appraises for $450,000, the bank will loan 80% of the lower number.
However, if the bank's loan amount is based on appraised value, you'll need to know that appraised value to know how much cash you'll need. It's kind of a chicken-and-egg thing.
To summarize, here's the formula:
[Cash Down Payment = Construction Cost - Construction Loan Amount]
and
[Construction Loan Amount = Appraised Value X 80%]
If your house-to-be appraises for exactly the cost to build, you'll be able to get a loan for 80% of the cost… and you'll need the other 20% in cash.
However, with a bank willing to loan 80% of appraised value (NOT just 80% of cost), you can borrow more if the appraised value is higher than the cost to build.
This happens regularly—and you can learn more about it in our free guide: “Build Your Forever Home on Your Land.”
For example:
Your building contract is for $500,000. Let's say the appraisal comes in at $550,000. Your banker will then lend you 80% of $550,000, which is $440,000.
That means you'll need:
$500,000 (cost to build) - $440,000 (construction loan) = $60,000 in cash.
That's $40,000 less than if the house appraised for exactly the cost to build.
You need the appraised value
In every scenario, the variable that you don't know up front is also the variable you need to determine your cash down payment. That variable is the appraised value.
The only way to get that number is to do the appraisal.
If cash is tight, it might be worth it to pay for the appraisal. The $400 (or so) you spend on the appraisal is an investment in finding out whether you'll be able to make your dream happen now, or if you'll need to put it off until you have more cash.
If you’ve got cash to spare and only need to get a rough idea, use the formula and don't worry about the appraisal just yet. Just remember: your estimate will be off a little bit, depending on the results of the appraisal.
If you need to know the exact number, get the appraisal done, and you'll be glad to have shed light on the unknown.
For more help on the whole process of going from raw land to finished house, download my free guide, From Raw Land to Forever Home.
