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| The Basics | How to pay for your dream house
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If the perfect home starts with an empty lot, a conventional mortgage won't do. Here are the basics on construction loans, bridge loans and convertible loans, plus what to expect in rates, fees and the process.
By Liz Pulliam Weston
If you want to buy a home that somebody else built, youll have no trouble finding reams of information -- and lenders -- willing to help you.
If you want to build your dream home, however, the road gets rockier. Construction loans arent as easy to find, or understand, as a traditional 30-year mortgage. Not all lenders offer construction loans, and those that do vary widely in the kinds of terms, rates and fees they offer.
Few would-be homebuilders can do without a construction loan, however. Only about one in five people who build a new house pays cash, according to Census Bureau housing statistics.
So if your heart is set on creating a home from scratch, heres what you need to know about borrowing the money to start turning your dreams into reality.
Two types of construction loans
First, the basics. Construction loans are short-term, interest-only loans that are typically designed to be replaced by a regular mortgage once the home is built. These loans are offered by regional banks, mortgage companies and some national lenders, including Bank of America and Wells Fargo.
Construction loans come in two basic flavors:
- The all-in-one loan (also called the rollover or the construction-to-permanent loan), which automatically reverts to a standard mortgage after construction is completed, and
- The construction-only loan, which comes due at the end of construction and must be paid off or replaced by a conventional mortgage.
Both approaches have their fans. All-in-one loans have one set of fees and one closing, reducing the hassles for buyers, said mortgage broker Allen Bond of Palos Verdes Funding in California. Although many all-in-one programs convert the construction loan to an adjustable-rate mortgage, some plans offer 15- or 30-year fixed-rate mortgages.
But shopping separately gives consumers more choice, because they can select from the thousands of conventional mortgage loans available rather than being restricted to the mortgages offered by construction lenders.
This approach lets the consumer wind up with the kind of loan they really want for the long term, said Ginny Ferguson, vice president of the National Association of Mortgage Brokers.
What you'll pay in rates and fees
In either case, the interest rate youll pay on the construction loan is typically fixed for the life of the loan -- usually 12 months or less, although some stretch for 18 months. The rate for people with good credit is usually the prime rate plus zero, one or two percentage points. At the current prime rate, that means a rate of 4% to 6%. Youll typically pay 1% or 1.5% of the total loan amount in origination fees, plus several thousand dollars in other fees to cover costs such as inspections (so the lender can make sure the project is proceeding according to schedule) and title insurance, which tends to be trickier with new construction.
They take a big chunk in fees, says Warren Christensen, a Los Angeles homeowner who recently paid $17,000 in fees to get an all-in-one construction loan that replaced his mortgage and provided him $135,000 for a major remodel and addition. The beauty of (the all-in-one loan) is that youre not paying fees again when you roll over, but its still a lot of money.
The higher cost reflects the risk of lending on an asset that hasnt been built yet. There are also fewer construction lenders than there are mortgage lenders, so the market lacks the kind of cutthroat competition that has helped drive down costs for regular home loans.
Christensen, a publisher who with his architect wife has built or remodeled several homes in Los Angeles, recommends shopping around to get the best deal. Go to a bank that does construction loans and to a mortgage company, Christensen said. Go to three or four different places, because rates can vary greatly."
Construction loans also differ from mortgages in that they dont pay out all at once. Lenders typically dole out your funds in five to 10 draws timed to various stages of construction, such as:
- Grading the site and pouring the foundation
- Framing the house
- Installing heating, air conditioning, plumbing and wiring
- Finishing the exterior
- Installing drywall or other interior surfaces
- Installing cabinets, fixtures and trim
- Interior painting and other finishing touches
The money is typically paid after each stage is completed, not before -- although some lenders recently have loosened up on this standard, said mortgage expert Razmik Vartanian of Mark 1 Mortgage, by disbursing just enough money to cover deposits on supplies.
Construction loans also differ from mortgages in how lending companies determine how much you can borrow. Conventional mortgage lenders base their loan maximums on the current value of the property and loan 80% to 90% of that value. Construction lenders, by contrast, may use the estimated future value of your property -- what the home will be worth after its completed -- or may base the loan on how much the project is expected to cost.
Containing your costs
Say you found a lot for $100,000 and plan to spend $200,000 designing and building your castle. The lender might require $5,000 in loan fees, plus interest and contingency reserves of about $20,000. The total loan would be for $260,000 -- 80% of $325,000.
Dont expect to cut costs by acting as your own contractor unless youve had significant experience in construction. Most lenders insist that borrowers hire a professional contractor.
I have done a few construction loans for borrowers that had experience building and acted as their own contractor, said Bond of Palos Verdes Funding in California. The lender needs to have the confidence that they have the experience to handle the job.
The best way to contain costs, home remodeler Christensen said, is to plan carefully and stick to your plan, because its so easy to get carried away. Suddenly youre spending $1,000 on spa tub faucets and upgrading every surface in sight -- only to run out of money before construction is finished.
It sounds funny, since this is your dream home, but you really do have to rein in your desires, Christensen said. You need a little self-censorship.
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