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How Do Construction Loans Work for Custom Home Financing?

how to construction loans work for custom homes

Custom Home Financing 101



If you’ve ever thought about building a new home, either on your land or in a planned development, chances are you’ve wondered exactly how you would pay for it, especially if you own an existing home. Managing two full mortgages is not ideal for most people. Luckily, there is a new home financing product called a construction-to-permanent loan that will allow you to build your dream home in a more manageable way.


Under normal circumstances (and this is what most traditional lenders will tell you) you’d need two loans to finance the construction of a new home: one loan for the land and construction process, and another for the cost of the home (a traditional mortgage). That would require two applications, agreeing to terms for two loans, and two closings. That’s a lot to manage on top of your existing mortgage. With a construction-to-permanent loan, you apply and qualify for one loan that finances the land, construction, and home, and you close only one time, with one set of closing costs. Here are the details:


Terms of a Construction-to-Permanent Loan


If you already own the land on which you are building, you can use its equity for the down payment of your construction-to-permanent loan. The lender will hold your land as collateral, and should a loan default occur, they would have the right to repossess the land and sell it. If you don’t already own land, and need to roll the cost into your new  loan, that’s also doable. You’d need to come up with a 20-30% down payment for the total cost of the loan.


We should note here that most traditional home mortgage lenders consider construction loans to be high risk. It is a niche product, so it’s important to find a lender that understands them and will work with your builder to get them done. Lenders that offer construction loans often have strong relationships with a select number of builders with whom they have successfully completed new home construction loans, and prefer to work only with those builders. 


Once you’ve been approved and agree to the terms, you’ll close on your loan and begin paying interest-only payments during the construction process. The builder will request milestone payments from the lender throughout construction (supported by detailed documentation), the lender will disburse funds, and that is the amount that you will pay interest on, usually for up to 18 months. 


Once your home is complete, your construction-to-permanent loan will then default to a standard 15-year or 30-year fixed-rate mortgage, and you will begin paying principal and interest just like a traditional home mortgage. 


Construction-to-permanent loans have two main advantages:


1) It is a more streamlined loan product for new construction, with only one application and approval process, one closing, and one set of closing costs.


2) You can lock in your interest rate at the time of loan application, even if you won’t start paying toward the principal amount for a year or more. 


The only downside to this type of loan is that it does require more paperwork, including additional financial records from you and more plans and specifications from your builder. But the benefits of a streamlined loan product and lower interest rate certainly outweigh any extra time that you might spend gathering additional documents. 

For a list of preferred lenders who have successfully completed construction-to-permanent loans, or if you have any other questions about new home financing, please contact us.


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