Building a new home is an emotional roller coaster. It’s a high-risk project that requires a lot of time, money, and stress. Building a home is often more expensive than purchasing an existing home and never goes quite according to plan.
However, there’s no better way to get the home you want than to build something completely customized. It’s a great option if you’re planning to stay there for the foreseeable future.
Here’s what you need to know about the nuances of new home construction loans and financing.
Types of Construction Loans
Construction loans are financing options for people who want to build a new home rather than buying one. There are a few types of loans that fall under this umbrella: construction loans and renovation loans.
When building a new home, you’ll want one of two construction loan options.
Construction Only Loans
A construction only loan is a short-term loan that covers the construction period. When the construction is complete, the borrower must pay back the loan in full. This option isn’t for everyone. If you have a significant amount of cash to work with, or you know that the sale of your existing house will cover the cost of your new build, you can use this option. If you need a mortgage, this isn’t the new home construction loan for you.
This type of loan covers both the construction and the continued cost afterward. In other words, it converts the construction loan into a mortgage to cover the balance of the loan. During the construction period, the bank will pay the builder directly. When the construction is complete, you lock in your interest rates and start paying for your home.
Construction Loans vs. Mortgages
There are a few key differences between construction loans and mortgages. When you purchase an existing home, the bank pays for the house in a lump sum, and you pay them back via your mortgage payments. In a construction loan, the money is doled out to the contractor as the project progresses— also known as a “draw.”
Construction loans are also harder to qualify for than mortgages. Additionally, as these loans are short-term, they have higher interest rates. Construction loans take a more structured approach to the money management process but offer more flexible terms that fit the needs of your project.
Tips for Securing a Construction Loan
Whether you’re hoping to build now or in the future, it’s never too soon to start preparing your finances for a new home construction project. Here are the top tips to help you qualify for a construction loan.
Improve Your Credit Score
Generally speaking, construction loans require a higher credit score than a mortgage. This prerequisite is because construction loans are considered to be higher risk. With a mortgage, you’re paying for an existing building that a bank can repossess. With a construction loan, you’re paying for something that doesn’t exist yet.
Improving your credit score to be 680 or better is ideal for securing a construction loan. Set aside time to identify and remove collections from your credit report and pay down your existing debts to improve your debt ratio. It’s worth starting this process years in advance, as the higher your credit score, the better terms you’ll be able to secure. Implement positive financial habits to continue the momentum of your efforts after you hit the minimum threshold of 680.
Set a Reasonable Budget
One of the most challenging aspects of building a home is setting a realistic budget. Keep in mind that you need to be able to make the payments with your current income and also account for the inevitable surprises that occur when building a home.
Choose a home plan that suits your needs, and create a priority list. Identify which things you consider a necessity, what additions would be nice to have, and what aspects are a luxury. Use this plan to get a better idea of the overall cost by reaching out to contractors. From there, you can start eliminating certain features to fit your budget.
Find a Reliable Contractor
Perhaps the most important aspect of building a new home is finding a reliable contractor. You’ll need a detailed construction plan from a contractor before you can secure your construction loan. This should outline the overall expected costs and timeline. Without this detailed document, you won’t get the financing.
It’s important to shop around and use word-of-mouth recommendations when seeking a contractor in your area. Don’t just choose the contractor who submits the lowest bid. If one contractor’s bid is significantly lower than the others, it shows that they’re trying to undercut the competition. Those cuts will be reflected in the quality of your build or in added surprise costs later on.
Building a home isn’t a decision to be taken lightly. You should allow years of planning and financial preparation before you start a new home construction project.