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What You Need
to Know Upfront
- Understand what it takes to build your home:
you really ready to build your dream?
much does it cost to build a new house?
- Define the type of construction:
- Custom home
where the construction is based on a custom design
and individually build for the home owner
- Production home
where the construction is based on 3-4 different
"production" designs for a particular
neighborhood. The homeowner may buy one of the
plans from the builder and construct the house
as specified. Some production plans allow for
structural changes at additional costs.
Understand the steps
needed for a successful project:
- Can you afford building your home? Can you qualify
for construction financing?
These questions are reviewed in this file starting
with: Calculating the Numbers.
- You need to define the project requirements.
How many rooms, what is the square footage, how
should the rooms adjoin?
- What kind of foundation do you need?
- You need to find the lot and neighborhood
- What kind of home style are you looking to build
- Need to search or custom design your house plan
- Need to setup the construction specification
- Find a contractor to price the project
- Get bank approval for the construction project
- Manage the project
- Stay within budget
- Close on the construction financing / mortgage
Review house plans and other architectural plans
see our Step
4 for our house plan directory
Home Construction Financing
- What is a home construction
You will need to qualify for a construction loan before
meeting with a builder. The construction loan will
have a set limit that you can borrow (based on your
qualifying ratios: see
Step 5), which will determine the expense of your
construction project in addition to the up front money
that you will invest in the construction.
There are basically two types of loans involved when
constructing your home:
- Construction Line
This is a credit line that the lender setups on
your behalf for the payment of contractors and supplies
during the construction phase of your home.
Cash disbursements may vary by lender. Typically,
the first disbursement buys the land and then successive
disbursements will be made when certain phases in
the construction project have been completed.
Most lines have a term of about 12-18 months, depending
on the size of construction and area. Some lenders
will offer an extension if needed, but often with
up front penalties.
You will pay interest on the amount that you borrow
from the line during the construction phrase. The
interest rate on construction lines are slightly
higher than residential mortgage rates.
- Permanent Construction
Loan (residential mortgage):
At the end of the construction phrase, the line
closes and the amount borrowed is paid off with
a mortgage loan of your choice.
Many lenders offer the combined construction line
and permanent loan as a bundled product. There are
advantages and disadvantages. See
our discussion on construction/permanent loans.
If you are unable to obtain the combined construction/perm
loan with the same lender, you will need to:
- first qualify for long-term financing (i.e.,
mortgage loan) with one lender and then,
- meet with a second lender for the construction
line of credit these lenders will typically
extend credit once you have the permanent loan
Mortgage lenders expect owners to use a portion
of their own money to finance their home construction.
The standard percentage varies, but averages range
from 5-10% or more of the home's future value (as
determined by the lot, construction plans, and independent
Some lenders now allow for lesser percentages
as little as 3-5%, provided that you have good outstanding
Existing homeowners often use the equity value
of their existing home as required up front money
for construction loans. They may take out a home
equity line of credit to pay the up front money
or a percentage of the estimated construction cost.
For more information about home equity lines: see
our affiliated site at YourEquity.Com
Note: IRS rules allow for an one-time distribution
from qualified IRA accounts without the 10% penalty
for acquisition of a home for first-time home buyers.
See IRS publication 590 for information:
We quote from the IRS
Can I withdraw funds penalty free from my 401(k)
plan to purchase my first home?
If you are less than 59 1/2 years of age, you cannot
withdraw funds from your 401(k) plan to purchase
your first home without being subject to a 10 percent
additional tax on early distributions from qualified
However, depending on the rules for your 401(k),
you may be able to borrow money from your 401(k)
to purchase your first home. Your plan administrator
should have written information about your particular
plan that explains when you can borrow funds from
your 401(k) as well as other plan rules.
424, 401(k) plans
If I can't withdraw funds penalty free from my 401(k)
plan to purchase my first home, can I roll it over
into an IRA and then withdraw that money to use
as my down payment?
Yes, if you are receiving a distribution from a
401(k) that is eligible to roll over into a IRA
and you meet all of the qualifications for an IRA
distribution for a first-time home buyer. Your plan
administrator is required to notify you before making
a distribution from your 401(k) plan whether that
distribution is eligible to be rolled over into
To see if you qualify for a distribution to be used
as a first-time home buyer, refer to Publication
590, Individual Retirement Arrangements (IRAs) (Including
Roth IRAs and Education IRAs).
- Discount Points:
Discount points are up front fees that lenders
charge in order to offer you a lower interest rate
on your permanent construction mortgage.
A point equals 1 percent of the mortgage loan amount.
For example, if the lender charges 2 points on an
agreed loan amount of $100,000, your point fees
will be $2,000.
Many lenders offer mortgage loans with zero points.
These products generally carry a higher interest
Typically, each point that you pay on a 30-year
loan lowers your interest rate by 0.125 of a percentage
point. This reduction may vary by lender.
Compare rates vs. points calculation - from Dinkytown.net:
- Closing costs:
Closing costs are incurred costs associated with
the closing your home construction loan. There
could be closing costs for the construction line
and additional costs for the permanent loan, especially
if you use different lenders for each product.
These costs include lender fees, prepaid fees,
title search, recording fees, surveyor's fees,
attorney fees, and other closing-related fees.
Closing costs can average about 3-5% of the total
construction cost, including points.
Cash Reserve Account:
It is highly advisable that you set aside a cash
reserve account before starting your construction
You may need this "extra" money for
building deposits, cost overruns, construction
changes and requested upgrades.
There are too many "horror" stories
of construction projects coming to a stop because
of the lack of funds. Review
Step 8: Managing Construction Costs.
Many homeowners will use the equity value in their
existing home to open a home equity line of credit
as their cash reserve account. In the event of
extra cash needed, they will draw upon their equity
line account for cost changes.
Caution: your existing home equity value may be
needed to close on your residential mortgage.
Make sure you run the numbers to determine how
much equity can be set aside for your cash reserve
- Add it up to estimate your up front payment and
safety net in the event your construction costs exceed
- You may want to pre-approve
your construction mortgage loan before making construction
plans. You will be able to design your plans knowing
exactly how much you can afford.
- There is no obligation when you pre-approve for
a construction loan from a lender, nor does it obligate
the lender to provide you a loan.
- The pre-approval simply reviews
your credit and income qualifications based upon the
information supplied. The final approval will require
verification of your financial status and construction
- We can help get your pre-approval application started.
our financial network.
- Lenders typically use two key criteria in qualifying
you for credit:
- Your capacity to repay the mortgage loan
- Your outstanding credit report
- Your capacity to repay your loan is analyzed by
two lending ratios:
1: The "housing ratio":
calculated by dividing monthly housing expenses
by your gross monthly income. As a basic rule, the
housing ratio should not exceed 28%.
2: The "debt-to-income
ratio": calculated by dividing your
fixed monthly expenses by your gross monthly income.
As a basic rule, the debt ratio should not exceed
There is more information about these ratios with
a input sheet to calculate your own ratio: see
our Step 7.
- Your outstanding credit report lists any payment
delinquencies that you may have had over the past
- The report can be a factor in a lending institution's
decision to approve or decline your mortgage application.
You should review your credit report for any errors
before applying for a mortgage.
- Allow yourself about 2-3 months prior to the loan
application for correcting of any errors that may
be on your report.
- You have the right under Federal Law to know what
is in your credit report.
- We invite you to visit our Credit/Debt Management
Center for complete information about:
and sustaining a good credit report
and qualifying for credit
in the credit report
your FREE credit report for review
corrections to your credit report
your monthly expenses