How to Finance Your Custom Home Build
EDUCATION
Congratulations! If you are reading this post you are most likely ready to build a custom home. For some of you this will be your forever home. While others are tired of relying on a production builder’s taste to determine how they live and how much it will cost. NO THANKS! Most likely you have at least financed one or two homes. The process of financing a custom home tends to be slightly different. I want to get this out before we go any further. When you purchase a home from a builder that he has designed and built..you are paying for his interest payments and overhead. I have sold 1000s of new homes for various builders over the last 17 years. At a minimum 6 months of carrying cost is adding to your purchase price after the home is complete. This alone could be 10’s of thousands of dollars. What am I saying? If you purchase a home from a spec or production builder, they most always plan that it will take 6 months for the house to sell from the time it’s completed. If you buy this home? You reimburse him for all this money.
We will discuss 3 main areas in the custom home building process;
Land Aquisistation
Construction Financing
Permanent Financing
Land
Most often you will have to purchase land to build your new custom home. Some people have inherited land from family and this will certainly save money. For the rest of use, we will need to purchase and or finance land. There are many local or regional banks that have loan financing products. Most often banks are more likely to finance land that is already developed. In this I mean some grading and utilities are in place at least. This can happen in a custom home neighborhood where the developer is selling the lots to both builders and end users. This doesn’t mean that you cannot finance raw land. In my professional experience, most people purchase their land at least 1 year prior to beginning the construction process. Why? A quality custom home doesn’t happen overnight. Most likely it can take a year to hire your builder, architect, interior designer and to assemble the rest of your team. It takes time to draw plans, create budgets, make selections, apply for permits and obtain your construction and permanent financing. In many cases if you pay cash for your land and hold for the land for 1 year prior to taking out a construction loan--most banks will offer a 25% equity credit for the value of the land that you own free and clear.
If you opt to finance your land most banks will require a 20%-25% down payment, 1 year financing term that can be extended, and rate as much as 2% higher than prime. Once you close on the land, you will be responsible for the taxes and insurance for the parcel.
Construction
When you purchase a home from a production or spec builder the risk is much lower for the bank. Typically said builder has a long running relationship with his preferred lender. Sometimes they function off (1) line of credit while others will obtain a loan for each home they build. Due to the complexity, many banks don’t offer construction financing. Don’t worry there are many options that are available. When you opt to build a house on your own as an owner builder or using a custom home builder--the banks have to consider a few things. Does the builder have a proven track record? Does he/she have the resources to complete the project on time and on budget? Will the homeowner abandon the project and leave them with a half finished house in a market they don’t really know? How specialized is the homeowner going and can we sell this house as the bank if needed? Considering these factors, in most cases you will be faced with tighter lending guidelines versus purchasing a resale home.
In most cases be prepared with a 720 or better middle credit score.
20-25% down payment
12 month extendable build period
Interest Only Payments monthly during your build time
Rates slightly higher than prime
Prior to obtaining financing the bank will review your plans, builder’s background, drawings, anticipated appraisals, specifications, budgets and more. This is totally about protecting the interest of the bank. It is ultimately your responsibility to ensure that you are comfortable in the skill set and communication that your builder may possess. Rarely, will the bank intervene if you have a dispute with your builder...choose wisely.
If you have a balance on your land the bank will always want to be in first lien position. Any money owed on the land will be paid first. Typically, you do not have to pay off your land prior to building your custom home. It is important to keep in mind that during the construction process you will need to make monthly interest payments to cover the money your builder has “spent”.
Lenders have a formal “draw” process by which you or your builder can request funds for the project as it progresses, rather than giving a lump sum at the beginning. Most lenders operate on a monthly draw request schedule. When the builder submits a draw request, they will request a certain amount based on what is specified in your construction contract (usually either based on percent of completion or actual costs). The bank will then typically send out an inspector to verify that the work (for which the payment has been requested) has been completed. After verification, the bank will release the funds. The bank provides checks and balances to ensure that the funds are disbursed only for work that has been completed and that all material vendors and trade partners are paid. Lastly, most banks require and verify that progress lien releases are signed for each payment to minimize the chance that a vendor or subcontractor could file a lien for nonpayment.
Permanent
Once the house is completed, you will need financing in place to repay the bank long term for the house itself. There are a couple of major options.
Your bank may require that you refinance your total debt. There will be a new loan application and loan to value determination. Most often you can decide between adjustable and fixed 15 or 30 year financing. This by far is the more expensive option. I almost always suggest what we call a 1 time close. With this product there is 1 loan application, 1 appraisal, 12 month term with predetermined monthly payments to begin at the beginning of month 13. At this point your loan automatically converts to permanent financing.
Nothing is perfect but I tend to prefer a one time close product because your interest rate is fixed, the final appraisal is done speculative prior to building your home, and there is no added cost of a second closing.
This is by no means the answer or explanation for all the ins and outs of financing a custom home. I do hope that you have a better understanding of how to begin the process of building your custom home.
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