New Home Construction Loan

by Mack Bartlett

In 2006, my wife and I built our first home. It wasn’t a custom home – we built in a subdivision that had been created by one of the major builders in our area. Our new home construction loan was taken care of by the builder, and it was a very simple process. We like our home, but we’re afraid we’ll outgrow it within the next couple of years and it will be time to build again. We’d like our next home to be custom, so we’re going to have to educate ourself on the construction financing process. I’ve learned a few things so far.

First of all, construction loans on new homes usually fall into one of three categories:

1. The builder finances the home. Most builders of any size have relatively large lines of credit with banks that let them build the homes. When they complete the home the buyer is required to obtain a home loan on their own, and that loan is used to pay off the builder’s line of credit, as well as giving him his profits on the project.

2. The home owner takes responsibility for all financing, including the money to build the home followed by a permanent loan when the home is complete. In this situation the home owner seeks out a lender (usually a traditional bank, but I’ve seen people get private lines of credit from wealthy people as well) and secures a line of credit that will cover the amount of the construction. It’s rare that the bank will turn over the entire amount of the estimated construction cost at once; the home owner will usually draw on the line of credit as needed throughout the construction. They write checks on the line of credit to pay the builder as necessary.

Once the home is complete the home owner will have gone through a separate application process for a permanent mortgage (e.g. a 30 year fixed rate loan, etc), and when that loan closes the proceeds will go to pay off the short term construction line of credit.

3. Some lenders are set up to provide combination construction and permanent home loans. Meaning, the line of credit is drawn upon during the construction process (and ususally at a higher interest rate than the permanent loan will be) until the home is ready to live in. At that point the same bank will convert the loan to a permanent interest rate, and essentially ‘pay itself off.’

However you choose to finance your home construction loans, make sure you’re careful at every step in the process. When a bank gives you a blank check in the form of a construction line of credit, it can be very easy to make improvements on the fly, causing your home price, and your future mortgage payment, to balloon. A conservative approach to building your home will leave you with less stress in the long term.

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