Financing the dream

 

So the big question: How do we finance this little project? Getting a loan on a custom home is somewhat of a different affair than simply getting a mortgage. There are essentially three components that need to be financed: the lot purchase, the construction and the long-term financing once construction is complete. 

As with everything in this project, this is all new to me. From my research, there are several ways of financing our dream home. This is post real-estate meltdown where lenders are still very wary of who they hand loans out to, and a custom home construction is a bit riskier for the banks than a traditional mortgage. From what I've found up to this point, most lenders will require 20% of the cost of the entire project as down-payment. Anything less than 20% will likely come with a higher interest rate in addition to a private mortgage insurance requirement. From there on out, there are several options. I'll cover the ones that I've come across thus far.

1. Project financed entirely by buyer with a one-time close - This is the option we would like to use if at all possible. What we want to avoid is the scenario where we would have to finance the lot purchase and construction separately from the long-term financing once the construction is done. This is sub-optimal in that we would have to pay two separate closing fees. We threw this option out the door right off the bat.

The one-time close applies to ARMs (typically 7 and 10 year) and 30-year mortgages. The ARMs usually come with a lower interest rate so if you are confident you will either a) be selling the house or b) be able to pay off the loan within the ARM period, this may be the way to go. Otherwise, the 30-yr mortgages are currently at a historic low so this would be the best option for us at this point.

The way this works is that you take out the loan for the entire projected cost of the project minus the down-payment. During the construction phase, interest-only payments (prime + 1%) are made on a monthly basis based on how much money is drawn from the loan that month. As construction progresses, the draws each month will increase (as will the payments) until the loan is exhausted in its entirety. Ideally, construction will be finished at this point and everything will be ready for move-in and conversion of the loan into a traditional mortgage.

As you can see, it will be extremely important to get the planning and cost projections as accurate as possible. Estimate on the higher side of things because the last thing you want is cost overruns during construction and realizing that you didn't borrow enough money. You can see how this could potentially cause huge problems and headaches down the road. There's a rule of thumb that one can reasonably expect the cost of the project to run up to 10% more than initially estimated. Build this cushion into your loan if at all possible. From our standpoint we plan on taking our time in the design phase, hammering out every detail so that nothing is left to chance and there won't be any huge changes needed to the plans once construction begins.

2. Builder-financed construction - I'm not sure if I have this right, but I think that with this option, the builder takes out the loan for the project. The advantage of this option is that the builder may be in a better position than the buyer in securing the loan. The builder would act as a middleman of sorts and he will build in some profit for himself (usually by means of a higher interest rate). 

If you decided to go with this option, the main disadvantage would be that you'd be committed to using this particular builder. This will likely cost you some potential savings since you won't be able to have several builders bidding for the job once your design is complete. The other difference is that during construction, you will be paying the normal monthly payment as if it were a just a traditional mortgage (since the builder has essentially secured the entire loan already), and the long term loan would be transferred/arranged by the builder once construction is completed.

This may be an appealing option because of convenience and ease since you don't have to go through the process of securing the loan, but it comes at a premium. We are trying to avoid this option for several reasons: the added cost and the fact that we wouldn't have any options in terms of builders.

I'm sure there are many other variations on the two options mentioned above, but this is currently the gist of what the lender proposals being thrown out to us right now. If any significantly different offers come along down the road, I'll be sure to post separately about them.