Will 2021 be the year that you build your dream home? If so, you certainly will not be alone.
Fannie Mae predicts new home sales to surge by 5.5% in 2020, with roughly 1 million new-constructly new homes to hit the market by 2021.
Building a home enables you to live in something you helped create. Within certain limits, you can build an abode with the ideal amount of space, configuration and amenities in a location best suited for your needs.
But before you hire a contractor and start drawing up plans, you should realize that financing home construction is more challenging than obtaining a mortgage on an existing home.
In fact, if you’re a medical resident or just starting your medical practice and still paying off a load of student loan debt, you probably shouldn’t consider building a home. You already have enough going on in life to take on the challenges of a having a home built.
For starters, you will find it difficult, if not impossible, to find new home construction loans that provide the same benefits as physician mortgages.
Physician mortgage loans are a special type of financing that address the unique financial challenges of medical professionals who begin their careers later and rack up more student loan debt than most professionals. Doctors who qualify can get mortgages that waive some requirements of traditional mortgages with little to no downpayment.
For the most part, financial institutions that provide physician mortgages do not make them available for financing new home construction.
That’s because the lender is taking on more risk with new construction because there isn’t a property to use as collateral to secure the loan. In addition, the cost of building a home can fluctuate during the time when the loan is granted to when the house is finished.
The simplest path to financing new home construction is to have the builder finance the project. Once the house is completed, you can “buy” the property from the builder by obtaining a doctor home loan from a mortgage lender.
Chances are, you won’t be in the market for new construction unless you have already owned a home and are planning to upgrade. If this is the case and you have enough left over after the sale of your existing home, you can use the proceeds to obtain traditional construction financing. Here’s how it works.
You will likely begin the process by obtaining a construction loan. This provides financing for the actual building of the home. This financing usually lasts six months to a year.
Once construction is completed, the homeowner obtains a permanent mortgage that pays off the construction loan.
With traditional construction loans, banks usually require a downpayment of at least 20 percent to 25 percent of the total building costs, including land acquisition. If you already own the land on which the home is to be built, you can use that as equity on the loan.
In addition, lenders typically require higher credit scores and charge higher interest on a construction loan than a traditional mortgage.
Gaining approval for a construction loan requires the lender to approve the construction plan, which includes the blueprints, a timetable and overall budget.
Unprepared buyers can be surprised by the costs of building a house, which makes budgeting a challenge. Those interested in this type of financing should thoroughly consider the following cost categories:
Soft costs: This includes architectural plans, building permits, and engineering. You will also need to purchase insurance to protect against theft or damage during construction.
Hard costs: These are the actual building costs, including excavation, site work, building materials, labor and contractor fees. Hard costs are usually calculated on a per-square-footage basis.
Reserves: Lenders typically budget an additional 5 percent to 10 percent to deal with unplanned expenses, such as higher than anticipated material costs or the costs associated with project delays.
Closing costs: Similar to a mortgage loan, there are fees associated with appraisal, title, underwriting and administrative expenses.
Unlike conventional mortgages, lenders do not release all funds at once for construction financing. There is usually an installment schedule based on construction progress.
For example, the lender may release 15 percent to 20 percent of the loan amount to pay for site preparation and foundation work. The next installment would cover framing, then another for plumbing, electrical and other interior work.
Before each installment, the lender will have the project inspected to survey the process and ensure building codes and regulations are being met.
Once the home has been completed, the lender will roll over the balance of the construction loan into a standard mortgage.
Lenders will often combine the construction loan and mortgage into a single 30-year loan with one closing, which is referred to as construction-to-permanent financing. In this case, the loan has two parts, a one-year construction loan and a 29-year fixed-rate loan.
The other option is to refinance the construction loan into a regular mortgage. The downside of this option is that you will have two sets of closing costs.
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Joel Palmer is a writer and personal finance expert who focuses on the mortgage, insurance, financial services, and technology industries. He spent the first 10 years of his career as a business and financial reporter.