Home Construction Loans and Financing

January 2, 2018

Financing Home Construction

America’s new construction market is hot right now. In fact, homebuilder sentiment is at its highest level since the 1990s. This means that demand for new construction is on the rise. Demand is largely driven by a strong economy; unemployment is low, wages rising, and home values recovered. Read on for a guide to financing a new construction. Learn more about securing home construction loans.


Consumers and homebuilders alike are confident in the housing industry. In particular, new homes are a desirable option for home buyers.


However, the home construction process is vastly different than purchasing an existing home. Each milestone is different from the timeline to home construction loans.


New vs. Existing Homes

Before diving into financing, it is important to understand why buyers opt for new over existing homes. According to industry surveys, buyers prefer new over existing by a margin of 2 to 1.


There are many benefits to purchasing a new construction. For starters, the home is brand new and will not require heavy maintenance for many years.


Another big positive is that new homes are customizable. This means that you can design the perfect home, from the bathroom flooring to the kitchen light fixtures. You can influence the home design down to the smallest details.


What Are the Negatives to New Construction?

While these are enormous benefits, there are certainly disadvantages to buying new. One well-known negative is price creep.


Designing the perfect house is expensive. Small details such as finishes and cabinet hardware seem like minor expenses, but add up quick.


Existing homes include upgrades that retain only a fraction of the investment cost. For instance, the addition of a swimming pool adds a maximum of 7% to a home’s value.


This means that the seller paid tens of thousands for a new pool, and the buyer acquires this amenity for a fraction of the cost.


Buyers of new construction pay full price for amenities that depreciate in value, just like a swimming pool. When it is all said and done, new homes are up to 20% more expensive than an analogous existing home.


All that being said, for many buyers, the benefits of new construction outweigh these negatives. The price premium is worth it for a new roof and an uninhabited home.


If that is the case, it is time to investigate home construction loans. The primary takeaway here is to consider price creep in the financing amount. As a design-build firm, our proprietary process streamlines your project and budget, eliminating price creep.


Check out our article on the advantages of working with a design-build firm.


What Type of Home Construction Loans Are Out There?

There are two types of home construction loans. The first is called a construction-to-permanent loan.


For this type of loan, you finance the construction up front. When the home is completed, the lender converts the loan into a standard mortgage.


The second type is called a stand-alone construction loan. Simply put, this type of loan pays for construction only. When the home is complete, you apply for a second loan to cover the builder’s incurred debt building the home.


Each type of loan has positives and negatives that you must weigh before selecting an approach.


Construction-to-Permanent Loans


Of the two different home construction loans, this is the preferred choice for many. The most substantial benefit is the requirement for only one closing. This greatly benefits the buyer as only one set of closing fees is imposed.


Another benefit is that interest is only charged on the existing construction balance. This saves you money as interest payments on the total mortgage amount would be much higher.


Construction-to-permanent loans also afford the opportunity to lock in an interest rate. This is a popular move among American borrowers to mitigate the risk of increasing interest rates.


For instance, consider the possibility that the Federal Reserve decides to raise interest rates while your home is being constructed. This action is likely to increase mortgage rates, meaning a higher monthly payment for the next 15 or 30 years.


To address this inconvenient possibility, borrowers can pay points to lock in an interest rate ahead of closing. To pay a point, the borrower simply pays 1% of the loan amount upfront.


Construction-to-permanent loans do have a significant negative attribute. This type of loan typically requires a down payment of 20%, which is difficult for many buyers.


Stand-Alone Home Construction Loans


Remember, the stand-alone construction loan requires 2 separate loans to move in. The first loan covers construction expenses. The second loan is a traditional mortgage.


The greatest benefit to this type of loan is that down payments less than 20% are more common. For cash-strapped buyers, this may be the only option to purchase a new construction home.


After construction runs its course, the cash-strapped buyer can then pursue an FHA loan with a 3.5% down payment. Electing this type of financing is also good for buyers that have not sold their current home yet.


While this is a significant benefit, there are a number of negative attributes to this type of loan. For starters, you are required to pay closing costs twice.


Another negative is the inability to lock in an interest rate. Because the loans are treated separately, you are exposed to volatility in the rates market.


Lastly, you run a greater risk of failing to qualify for the mortgage. If your financial circumstances change during construction, it may hinder your ability to secure a mortgage.


What Are Some Other Financing Options?

There are a few other ways to secure financing for a new construction. Some banks offer a bridge loan that allows you to utilize the equity in your current home.


This option gives you access to funding while you wait for your home to sell. However, this is viewed as a risky proposition in the event that the home does not sell quickly or closes for less money than anticipated.


Another potential option is development financing. If the construction volume exists, a builder may offer financing options to you.


Wrapping Up


Securing a home construction loan can be tricky, especially if you are tied up in an unsold home. Lack of liquid assets is another issue that routinely plagues buyers. The good news is that there are several financing options to pursue depending on your situation.