CONSTRUCTION FINANCING
INTRODUCTION
Whether you self-fund the construction or finance it through a lender, understanding the true cost to build a project can be confusing. As we mentioned in the Prepare section, understanding your financial commitment and your borrowing power are important early steps in confirming you can build the project. You should meet with your banker early on to understand how much you can get pre-approved for and then meet again later after design drawings are completed to get the paperwork together for your construction loan.
Let’s take a look at the process to secure financing.
KEY PROCESSES
Below are the common ways to pay for your home construction or improvement project:
- Self-fund
- Construction loan financing (for new construction)
- Home equity loans and lines of credit (for remodels and additions)
- Hard money loan
SELF-FUNDING
Only a small number of custom home projects are self-funded. This is sometimes the case if you sold or refinanced your home and have the cash. If you’re paying out of pocket for your home construction project, then you can skip to the next section, Award the Construction Contract. Just make sure you have your finances in order before the construction begins.
CONSTRUCTION LOAN FINANCING
Construction loan financing is the common approach to funding a new home construction project. While it’s not a loan process that a lot of lenders are familiar with, it’s the best option when building from scratch.
For most construction loans, lenders require you to submit a set of design drawings with your loan application paperwork. The loan amount is usually based on the anticipated value of the house after it’s built so the lender will require an appraisal to estimate the value based on your design drawings. That’s why the timing of submitting the paperwork for a loan typically happens during the building premit process with your local jurisdiction – because the drawings are nearly complete at this point.
To get a construction loan you need to complete several steps before applying to the bank. You should have:
- A lot/land (paid for in cash or currently being financed with a lot loan).
- Your finances in order
- Your construction drawings submitted to the building department
Timing – Most lenders won’t fund a loan until the building permit is issued. This is because getting a building permits is often one of the most challenging tasks of building a project. This benchmark is a good signifier to the lender that you’re serious about the project and ready to commit.
To understand the construction loan process, speak to your lender for more information. Here’s the general steps involved:
- Get pre-approval
- Prepare the paperwork
- Sign the application forms
- Appraisals & Underwriting
- Loan Application approval
- Loan disbursements
- Roll into mortgage
HOME IMPROVEMENT LOANS & LINES OF CREDIT
If you have a home improvement project, chances are, you currently have a mortgage on your home. This means you have few financing options to choose from for your remodel or home addition. Here are the most popular lending options for your project:
Cash-Out Refinancing – In this option, you would refinance your home (and get a lower interest rate) to finance your remodeling project – meaning you’d take cash out after refinancing. Refinancing has a significant amount of paperwork and more upfront costs, but can likely get you the lowest interest rate available.
Refinancing may be best if you’ve built up significant equity already, the property has increased in value, or if you currently have a high interest rate on your home. In these cases, it may make more sense to refinance rather than get a higher-rate second mortgage. Just keep in mind that your payments may go up even if your interest rate is lower. This is because you’ll be increasing the size of your loan to include the cash you take out for your home improvement project.
Home equity loans – These loans are second mortgages and offer the tax benefits of conventional mortgages. With these loans, you get the entire loan amount up front and pay it off over 15 to 30 years, like you would a traditional mortgage. The interest rates are fixed, and they tend to be slightly higher than those for conventional mortgages and refinancing, but lower than home equity lines of credit (see below). There are no closing costs, and paperwork is a lot easier than refinancing – some even getting approved on the same day and/or online.
A home equity loan may be best if you want a fixed rate, already have a great interest rate on the first mortgage, and don’t want to refinance. This loan lets you continue paying off your first mortgage at the low rate and just tack on a second payment.
Home-equity lines of credit (HELOC) – These mortgages work similar to credit cards where you have a limit to how much you can borrow and you draw funds as you need them. The difference is that the line of credit is secured with your home – meaning, if you don’t pay on time, you risk losing your home. You’re charged interest on the amount borrowed with adjustable rates that are higher than home equity loans. You can also use it again and again, borrowing money, paying it off, borrowing money again, etc. Repayment is usually 8-10 years. There are no closing costs and paperwork is easier than refinancing.
A home equity line of credit may be best if you are remodeling or doing home improvement projects in stages because you’re only charged interest on the amount you borrow.
FHA-203k loans – These FHA-insured loans allow you to simultaneously refinance the first mortgage and combine it with the improvement costs into a new mortgage. They base the loan on the value of a home after improvements, rather than before. Because your house is worth more, your equity and the amount you can borrow are both greater. Repayment period is usually the standard 30-year term.
There are other ways of borrowing for your home improvement project such as borrow against your 401k, IRA, or life insurance policy, but these may have penalties, fees, and result in long-term losses. You can also borrow with credit cards or store credit, but these have very high interest rates.
HARD MONEY LOANS
While not the best option to finance a project, hard money loans are a last resort option if you can’t get approved for financing using the above methods. Hard money loans usually have higher interest rates and require a large down payment but don’t have as strict lending requirements. If your credit score isn’t high enough for a traditional loan, this may be one of the few options remaining.
ACTION ITEMS FOR THIS SECTION
- Review your financial situation before committing to the project.
- Meet with your banker to review your borrowing power and what you can get pre-approved for.
- Decide which financing option is best for you.
- If getting a construction loan: Start the loan application process about 60 days before you anticipate the start of construction. Submit all necessary paperwork and design drawings for the loan application.
- If getting a home improvement loan or line of credit, check with your lender to see how long the process takes and what paperwork is involved. Start getting paperwork together at the appropriate time.
- Receive financing for construction.
Need more help? Here are additional resources related to this section.
BLOG ARTICLES
TOOLS & RESOURCES
All downloadable resources can be found in our Resource Library. Sign up to gain exclusive access.
- Checklist: Required Documents For Construction Loan Financing
- Spreadsheet: Project Cost Estimator
Over To You…
Acquiring construction financing can be stressful to many people. After going through this section, you should have a better idea of your financing options and timing. Knowing early on how much money you can borrow will help you design a project within your budget so when the time comes to actually build the project, you don’t have to stress about not having enough to complete it.
After securing construction financing, you’re ready for the construction process. But first, you need to make sure you select the right contractor to build the project and sign on the dotted line. We cover that in the next section.
