Part One: Choose Your Financial Instrument
If you own a home while building another can produce a significant drain on finances. If it’s your first venture into a custom build, this is an understandable concern.
Keeping in mind that we’re designers and builders, not lenders, our insights come more through osmosis than authority. But you may glean some enlightenment you can take to the bank.
Land Equity
If you already own land, the equity in the land will be included in the eventual construction project. The land will be valued at either:
- The difference between what you paid and what you owe (if purchased recently, say within the past 12 months), or
- The difference between an appraisal and what you owe.
This is a common practice but – as with everything mentioned here – these are generalities which may vary by lending institution, so you’ll need to check.
If you’re buying land concurrent to your building plans, your lender will include its cost in the project.
Construction Loan
A construction loan requires that you make interest-only payments during construction. The payments will vary month to month based upon the construction plan agreed upon by you, your lender, and your builder.
You’ll pay interest each month on whatever the builder drew the month prior. Again, this has all been agreed upon in advance.
Keep in mind that if you’re one of our clients, you’re never obligated to any expense to which you haven’t agreed. You make this agreement after a pricing meeting in which your specific home-finishing selections have been firmly quoted and the total project price established.
One more wrinkle on construction loans: you can buy land and later get a construction loan banded with it. Or if you have a mortgage on the land, you can convert it to the construction loan.
When the certificate of occupancy (COA) is ready, the construction loan ends. You’ll then need a mortgage to cover both the principal and interest. This will mean another set of closing costs and another determination of interest rate.
But there is another option.
Construction-to-Perm Loan
Possibly the most cost-effective way to finance a custom build is to utilize a construction-to-permanent loan. You’ll hear this financial instrument shortened to construction-to-perm, C-to-P, or even CP. The benefit of this product is that it saves you a set of closings costs and locks in an interest rate at the start.
“The benefit to this all-in-one approach is that there are no additional closing costs once construction is finished, and no other fees or underwriting,” explained Kayla Lea Jorgenson, mortgage loan officer of US Bank, in an interview on Lindal.com, “The loan and deed of trust is already done. Also, the interest rate is locked prior to the construction phase. If rates go up during any part of the process, it doesn’t affect the customer. In the event that rates go down, you can always refinance later.”
Again, it’s interest-only to cover the builder’s draw the prior month, with a mortgage activated automatically upon COA issuance.
You can also include a land purchase in this loan.
Lowering Payments with Home Sale Proceeds
You probably wish to stay in your current home until your new custom home is ready for occupancy. If you’re fortunate enough to sell your current home near the end of your custom home construction, you may be in time to make a principal curtailment before the mortgage loan is amortized, and set closing dates so that you step from your current house right into your new custom home.
But if your current home fails to sell with such precision timing, many lenders will accommodate a mortgage recast after the sale. This involves making a large, lump-sum principal-only payment which will trigger a reamortization of the revised balance, lowering your monthly payment.
Next in Part 2:
Submitting Your Financial DNA to Lenders