If you've decided to build a home rather than buy, financing your dream may become more complicated. Rather than a mortgage, you'll start out with a construction loan for building the house; while you can use a separate loan to buy the land, you can also combine the construction and land purchase into a single deal.
With a conventional mortgage, a lender knows exactly what he's loaning money for, and how much. Construction loans are trickier: There's nothing to appraise yet, no collateral except the land, and construction can suffer delays or cost overruns. Typically, you take out a loan with a variable interest rate; the contractor submits bills on a regular basis and your lender pays the bills then charges interest on the money disbursed. You make interest-only payments during construction, then the loan comes due when you receive a certificate of occupancy.
How you handle buying the land is up to you. You can pay cash and take out a loan for construction; take out two different loans; or combine a land loan and a construction loan into a single deal. Buying the land and building the house with a single loan means you only have one set of closings costs to deal with and requires less money on hand than paying cash. If, however, you can get a better rate on a separate land-buying loan taking out two loans might be the smart move.
Because of the uncertainty, construction loans have a higher interest rate than a mortgage. For that reason, home buyers usually take out a mortgage loan after construction finishes up, then use that to pay off the construction costs over time, rather than keep paying on the construction loan. You can do this in two separate loan arrangements -- though your lender may insist you apply for the mortgage before she approves the construction loan -- or you can use a construction-to-permanent loan, which automatically converts to a mortgage when construction is done.
If you already own a home, you can use that as collateral for a home equity loan, then use the loan proceeds to buy land or help finance the construction. If you can get a better interest rate than on a construction-and-land loan, and if there's no penalty for prepaying the home equity loan early, this might work out better for you. You can repay the loan when you sell the house, provided you can make a prompt sale for a good price.
- Bankrate.com; How Construction Loans Work; May 2002
- lendingtree: Get Acquainted With Home Construction Financing
- Bankrate.com; Financing the Building of a New Home; May 2002
- TD Bank. ”Build a Home.” Accessed August 21, 2020.
- Quicken Loans. ”Construction Loans: What Are They, And How Do They Work?” Accessed August 21, 2020.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.