Building Your Own Home: What to Know About Construction Loans

New residential construction home framing against a blue sky. Roofing construction. Wooden construction

For some, the thought of building their own home might be a thrilling prospect. After all, when you choose to build your own home, you get to call all the shots.

You have the freedom to choose the home’s design, layout, number of bedrooms and bathrooms, overall size, fixtures, finishes, and more. If you must have a walk-in pantry, coffered ceilings, or a master bedroom located on the main level, you can ensure those needs are met during the design process. But when it comes to financing the construction of your new home, there are several things you should know.

Construction loans are very different from the garden-variety conventional mortgage loans that are readily available in the market. Most banks and credit unions offer conventional mortgage loans, but appreciably fewer offer construction loans. The main hurdle for many when pursuing a construction loan is the need for substantially more cash on hand when compared to buying an existing home. This is because banks will restrict the construction loan amount to a lower percentage of the home’s value, thereby requiring more cash from you.

There are two ways to pursue a new home build, and which path you take will ultimately depend on who will finance the construction of the new home. Some builders will finance the build for you “on their own dime” and then sell it to you upon completion. This is known as a pre-sold spec build. Typically, the builder will allow you to choose a lot in their development floor plan followed by your selections for upgrades and finishes. Occasionally, the builder may even allow some minor tweaks to the floor plan or home design. A price is then established, and a Purchase and Sale agreement is created. The builder then builds the home and you purchase it from them when the home is completed. With this type of build, ordinary mortgage loans would be available to you and you would not need a construction loan. On the other hand, if the builder requires you to finance the project, you will need a custom construction loan, and this will be our focus.   

To obtain a custom construction loan, you will first need land. If you already own your land, you are off to an excellent start, and any equity you have in the land will be credited towards your down payment for the construction project. If you do not own land, you will need to purchase it – this can be done ahead of the construction project or as part of the construction loan process.

When purchasing land ahead of the construction project, you will need to either pay cash for the lot or identify a financial institution that will finance it. While few banks offer construction loans, even fewer offer lot loans; and the terms on lot loans are markedly different than those of a mortgage or construction loan. If you have found the lot that is perfect for you, but you haven’t finalized your plans with a home builder, you will need to forge ahead with the land purchase and obtain the construction loan later. On the other hand, if you’ve already chosen a builder, finalized your plans and specifications, established the cost budget, and then find the lot you want to purchase, you can bypass the lot loan and instead obtain a construction loan. Essentially, the first advance on the construction loan would be to purchase the land, and then the builder would immediately proceed with building the home.

So now that we’ve covered the basics, how much money will you need to build your home and how much will the bank lend? The first step is to establish the total project costs. With a construction loan, there is a cost-basis element to the project that the bank will focus heavily on. To establish the total project costs, the bank will take the land purchase price and add to it the construction contract amount with the builder. For example, if the land is being purchased for $150,000 and the build costs amount to $350,000, then the total project cost is $500,000. Typically, you will need to fund 15-20 percent of the total project cost yourself with cash. As the project cost increases, you may need to plan for a higher cash injection percentage. On a million-dollar project, for example, the bank will likely require a higher percentage from you, perhaps as much as 25-30 percent. Moreover, the bank is going to require that you put your money in first before any draws on the construction loan will be allowed. To that end, if you are relying on cash from the sale of your current home to fund your new build, you would first need to complete the sale of your current home.

Finally, having come up with your required down payment, you are still going to need a reserve cash account. Because construction projects can have unexpected costs (and they often do), the bank will want you to have roughly 5-10 percent of the build cost in a reserve account. Using our earlier example, with construction costs of $350,000, an estimated $17,500 to $35,000 in post-closing liquidity would be required by the bank. The homebuilder may incorporate a “contingency” line item in the budget that can be used to help meet this requirement. Ultimately though, you are going to need to plan on having some cash left over after your initial cash injection to handle any cost overruns, contingencies, or changes made during construction.

Many of the items normally associated with a mortgage loan are relevant to construction loans as well. The bank will be reviewing your credit report, income, assets, and debt-to-income ratio. To obtain a construction loan, you will need to have an excellent credit history. While programs exist that allow people to purchase homes with less than perfect credit, no such programs exist for construction loans. Also, as is the case with purchasing a new home, if you already own a home and do not plan on selling it prior to obtaining your construction loan, your debt-to-income ratio will need to support both your current mortgage payment plus the new construction loan payment. Accordingly, if you want to remain in your current home while your new home is being built, you will typically need to be a higher income earner.

Construction Loan Types

There are two primary types of construction loans. Some banks will offer an all-in-one construction loan while others provide the construction loan with a separate mortgage at the end of construction. Some may refer to the latter as a “two-step” closing, with the mortgage obtained at the end described as “take-out financing.” The differences between the two programs are many (and too broad to discuss here), but it is important to understand that each program has its own features and benefits, and you should take time to learn the pros and cons of both. With either program, expect lower payments during the build as construction loans offer interest-only payments. As the builder makes progress on the home, they will request draws from the bank to pay for completed work, and they will do so incrementally during construction. As such, the construction loan will begin with a small balance and grow over time causing your interest-only payment on the loan balance to step up during construction and peak when the home is at or near completion.

Building your own home can be an exciting and rewarding process. Expect some hurdles along the way and probably some stress, too. But if you can begin your project with a firm understanding of how you are going to finance your build, you will be off to an excellent start.

David Doak, NMLS#123911

Commercial and Home Construction Lender, Community First Bank

Home construction loans are often as unique as the home itself. Compared to more conventional mortgage lending, these loans usually require a larger cash injection and need to follow additional contingencies.

To learn more on how to finance your dream home, reach out to David at (509) 735-5004 for advice on your home construction build.

All bank products are offered by Community First Bank.

Community First Bank NMLS#409021. Member FDIC. Equal Housing Lender.