Money milestones: How to get your finances ready to build a home
Make sure you’re planning for the long haul and have your other affairs figured out.
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Building a new home offers some advantages over buying an existing one. You can choose your plot of land, customize the home to your liking and avoid competing with other buyers in an ultra-competitive housing market.
Building a new home won’t be easy on the wallet. It’s usually much more expensive than buying an existing home (the average cost of a new home in March was 10% higher than an existing home according to the National Association of Home Builders), even more so now that the cost of building materials has skyrocketed during the pandemic.
Before you start calling architects and builders, you need to do some financial prep. Here’s how to get your finances ready to build a new home.
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Unless you can pay cash, you'll to need a sizable loan to cover the cost of land, construction and the ensuing mortgage. When you apply for a loan, the lender will pull your credit to evaluate your creditworthiness. Having good credit will help you get your loan approved, and it can also save you money through lower interest rates and cheaper homeowners insurance.
Don’t wait until you submit a loan application to find out what state your credit is in. Pull your credit reports (you can get them for free at www.annualcreditreport.com) and review them to identify any areas for improvement or inaccuracies that need to be disputed.
The earlier you do this, the more time you have to work on building your credit so you can make the best impression on potential lenders.
The more money you can bring to the table up front in the form of a down payment, the more attractive you will appear to lenders. Providing a large down payment will also reduce the amount you owe overall. If you need a construction loan (more on that in a minute), you may be required to come to the table with at least 20% of the loan.
You’ll also have to consider the closing costs. Closing costs typically range between 2% to 5% of the home. Depending on how you finance the construction and mortgage, you may have to pay closing costs once or multiple times, as some loan types require multiple closings.
These costs add up to a significant chunk of money, so you should start saving now. Even if you think you have enough cash in the bank to cover the upfront costs, saving more now will help you minimize the hit to your savings.
Here are some tips for saving for a short-term financial goal.
Before you start calling builders, you need to know how you’re going to pay for it. Getting a loan pre-approval will help you understand how much money you’ll be able to borrow, and start to give you an inkling of your loan payments.
“Prequalifying before you meet with a builder is the easiest way to find out your budget. You’ll find out exactly how much house you can afford, determining your price range,” said Andrina Valdes, chief operating officer of Cornerstone Home Lending, Inc.
Remember, just because you qualify to borrow a certain amount doesn’t mean you have to borrow the max. It’s a good idea to consider how much you can reasonably afford on a monthly basis, not just how much the bank will lend you.
You will need to either get a pre-approval for a traditional mortgage or a construction loan.
If you are planning to buy a home through a builder who is constructing several homes in a planned community, you might be able to arrange a traditional mortgage (depending on the community, builder and other factors). Builders can connect you with financing, or you can get your own mortgage loan through another lender. The biggest difference is that you will apply for your loan when you sign the contract with the builder, but the loan terms aren’t locked until the home is ready. You won’t close on your mortgage until you’re ready to move in, so if interest rates change, you may end up paying more or less.
For more information on the traditional home buying process, check out our guide on buying a house in 2021.
Most construction projects probably won’t qualify for a traditional mortgage because the home doesn’t exist yet. You'll need a construction loan, a short-term loan that covers the cost of building your home. Construction loans can pay for land, plans, permits and fees, labor, materials, closing costs and budget overruns.
Construction loans tend to have higher interest rates than traditional mortgages because they are more risky. The lender will disburse funds to you or directly to the builder through the course of the project at specific phases of construction.
“You might also need a lot loan since a custom builder doesn’t usually own the land they're building on,” said Valdes. “This is a separate loan used to purchase the lot for your house to be constructed on.”
There are two types of construction loans that are appropriate for new builds:
Construction-to-permanent loans, also known as single-close loans, pay for the construction project and are converted into a traditional mortgage once construction is complete. This means you only have to find a construction loan and mortgage once, through a single lender, and you can lock in your mortgage financing ahead of time.
Construction-only loans, also known as two-close loans, cover the construction phase only. They must be paid in full or refinanced into a mortgage when construction is complete. Unless you can pay off the construction loan by the time the home is complete, you will have to close again on a mortgage.
“A one-time close construction loan allows you to get approved for your permanent mortgage and construction loan at the same time,” said Valdes. “A two-time close construction loan functions as two separate loans but offers a bit more flexibility in the event of construction setbacks.”
Not all lenders offer construction loans, and you’ll want to do some shopping around for the best rates — you can always try your local banks and credit unions to get started. As mentioned above, most construction loan lenders will require at least 20% down payment.
Whether you need a traditional mortgage or a construction loan, you will need to go through the pre-approval process to get an idea of how much you can borrow and demonstrate your financial viability. The pre-approval process is much faster than getting final approval on a loan.
Once you’ve found a lender, you can submit information about your income, debts and assets. The lender will also pull your credit. The lender will use these factors to determine how much you are pre-approved to borrow. Remember that a pre-approval is not a guarantee of a loan — you still need to go through the loan approval and underwriting process, which is much more extensive, when you’re ready to move forward with a loan.
The lender may ask you to submit supporting documentation, like pay stubs, to verify your income and other information. For more information about getting pre-approved for a mortgage, check out our guide.
Once you’re pre-approved, the lender will provide a pre-approval letter that states the bank believes you have the means to purchase the home.
Just because you got a pre-approval from a certain lender doesn’t mean you have to borrow from them when the time comes. In fact, it’s a good idea to contact multiple lenders, provide your current pre-approval letter and ask if they can offer you a better rate.
Once your loan has been pre-approved, you can start moving through the steps required to get started on construction:
Find an agent: You don’t have to have a real estate agent represent you, but it’s a good idea. Agents can help you navigate the process, find the right builders and advocate on your behalf. Look for a buyer’s agent with experience in new construction homes.
Pick a lot: If you don’t already have the land for your home, talk to realtors to find out how much land will cost in the areas you’re looking at. Costs will vary depending on where you’re planning to build.
Pick a plan or hire an architect: New homes can be built from stock plans straight from a catalog. Finding the right plan can take some time. A custom designed home will require a licensed architect.
Build your team: The contractors you need to build your home may include the builder, excavator, surveyor, home designer and more. You can start by choosing the builder, who can hire and manage all the subcontractors (some homeowners want to be more involved and coordinate the work themselves, which could save money but requires a lot of commitment).
Negotiate a contract: Get bids from several contractors before you choose a builder. Once you choose the right builder, you will need to negotiate a contract that details the project and materials.
Submit the plan to the lender: A lender may request your builder’s work history, proof of insurance, blueprints, information about materials, a budget (including planning for cost overruns) and schedule. Make sure you have a detailed plan to submit to the lender. The builder may need to go through their own application process with the lender, and provide proof that they are licensed, insured and experienced in completing similar construction projects.
Submit the plan to other third parties: You may also need to submit building plans to local homeowner's association boards, city officials, town halls or other third parties depending on where you’re building (your builder or architect may be able to help you figure out where and how to submit building plans to secure approval and permits).
Building a new home takes time, especially when compared to closing and moving into an existing home. Make sure you’re planning for the long haul and have your other affairs figured out.
“It may take anywhere from three to seven months to build a new home from start to finish. Design and construction may take longer when working with a custom builder,” said Valdes.
For this reason, you need to know where you’re living during the construction process. If you’re selling your current home or renting, you need to have a plan for moving into your new home once it’s ready. And just like cost overruns, building projects can go over schedule — have a contingency plan for what happens if your project is delayed, like extending your current lease or renting back from the buyers of your current home.
Make sure you’re budgeting for the hidden costs of a new home — including delays in construction, furniture, landscaping, moving costs and more. You shouldn’t have too many updates to make since you’re building a new home, but maintaining a home also costs money so make sure to work that into your budget.
Need to supercharge your savings? Here’s how to save more.
The pre-approval process with lenders isn’t too complicated, and should go pretty quickly. Here’s how to get pre-approved.
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