New Construction 101
Buying a new construction home is very different from buying a resale property. In this in-depth guide, you’ll learn everything you need to know about the new construction buying process.
Working With A Custom Builder
Recent news has highlighted horror stories about problems with builders, poor quality, warranty items ignored and building sites abandoned half-finished. Most of this news is at the national level. The vast majority of developers in Colorado are both professional and capable. You can avoid a bad experience by knowing how to choose, manage and communicate with them. Here are ten tips to help you lay a foundation for a good relationship with your builder.
- Don’t approach too soon. If you’re planning to buy a new home, it may seem logical to start by contacting a builder, but don’t be too hasty. They are good at pricing once they know what you want. Asking for a price before you have any drawings or detailed information about your home plans is bound to lead them to tell you what they think you want to hear. My advice is to approach builders only after you have a set of drawings and a list of what you want and don’t want. If you don’t, you may end up basing the project on a figure that could be well under the actual cost.
- Consider what you want in a home and research builders with those skills. A luxury home builder must be organized and experienced. You need to see other homes they have completed and that your home is on par with their end product. They will usually have multiple managers, a well-organized back office, and teams that can operate around the clock. They produce exceptionally high-quality products quickly. These builders tend to be expensive. At the other end of the spectrum, some small owner-manager builders do a lot of the work themselves. They work on-site and organize everything from their cell phone. With low overheads, a developer like this should be much cheaper. On the other hand, the level of service, organization, and speed may not compare. You’re looking for the most appropriate balance of low price, high quality, and a good team. You’ll likely never get the best of all three, but it’s important to decide what will be the best fit for you.
- Determine whether you need a specialty builder or a general builder. An excellent general builder may be suitable unless the work you want is unusual. For example, a good general builder is perfectly capable of converting an attic or finishing a basement. You can go to a loft or basement company, and they may do as good or better for a lower price. The most important thing is to find someone who will do good work for the right price. With sharp design, a good builder can coordinate the right people (cabinet makers, electricians and so on) to build what you want.
- Your best bet is a builder as your single point of responsibility. Rather than using one general contractor, you may see it wiser to try to save money by directly engaging separate tradespeople such as framers, drywallers, electricians and carpenters. While it’s true that a general contractor will take a small slice of cost from the subcontractors, I would argue that this money is well-earned. Managing and coordinating the separate trades on-site needs lots of mettle and experience. I’ve seen lots of people who try to do the coordination themselves. They got into a horrible mess and ended up with a botched job that goes over time and budget. While it can work to pull out certain specific and well-defined parts of the work (for example, laying the carpet), I strongly recommend using one building contractor who will take responsibility for the entire project.
- Let your builder manage the project. It’s your builder’s responsibility to make sure that the right people in the right numbers are on-site at the right times and that they have the necessary materials to do their work. It’s important that the builder is allowed to run the project on a day-to-day basis. If not, there can be blurred responsibility if things go wrong. So choose a professional and let that person do his or her job.
- Be specific. I can’t emphasize enough how important it is to be specific. A set of drawings or architectural plans is a good start. Is structural detail paramount? You must make your needs and wants clear to the builder or project manager. In my opinion, you need structural calculations done by an engineer before you ask for a price. Beyond the drawings or plans, you must make clear exactly what the builder is being asked to include in the price. If the builder is also your supplier, then exactly which materials are selected and what is their quality? If you want to choose tiles yourself, who is supplying the adhesive and grout? Unless all these things are clear, there’s potential for misunderstandings and arguments over money once the work begins.
- Embrace bidding. It is important to have competitive bidding between the builders you are considering. The process of getting alternative pricing from different builders for the same work. It is crucial that the information given for their pricing is transparent and explicit. I recommend sending your project out to four or five builders for pricing. Pricing involves lots of work. It’s not fair, in my opinion, to ask for more than five bids. When the prices come back, it’s not at all unusual for them to vary between the highest and lowest by 100 percent or more. Make sure to compare the quality of materials used before making your final decision.
- Understand the importance of a building contract. A construction contract is an agreement between you and the builder for a set amount of money to deliver the home as planned and within the time agreed. There are many forms of a contract. The one that I most regularly use for residential projects has drawings or plans and schedules attached to the contract. Make sure you know what is included and what is not. The payment terms must be agreed to up front in the contract. The important thing the contract does is clarify the “what ifs” —such as, what if the work changes along the way? What if it takes longer than agreed? Ideally, once signed and filed, the contract isn’t needed again because everything has gone smoothly. But that’s because everyone knows it’s there in the background.
- Consider who will do the rough-in and finish work. After your foundation is complete, framing begins. With the kitchen, bathrooms and laundry rooms, the rough-in involves bringing the waste, plumbing, and electrical services to the right places. Plumbing pipes and electrical conduit and cables are installed in walls, under floors and are left poking out. Walls are then drywalled, textured, and floors laid before the finish work. The finish work is where the cabinets, appliances, faucets, light fixtures, tiling, and trim are complete. Finally, connecting the pipes and cables are finished. It may be that you ask your builder to do both, but it’s not unusual for the finish work to be done by the person who supplied the kitchen or bathroom. They will work perfectly as long as all parties understand in advance exactly what is (and is not) expected of them.
- Make a comprehensive inspection list. More arguments happen at the final stage than at any other time in a project, so it’s important to be ready for the common pitfalls. When the main work is going full tilt, everyone tends to be happy. At the end of a project, there are typically a thousand small items to attend to, requiring an array of tradespeople. These finishing touches are both challenging and expensive for the builder to organize. Combine this with the fact that you can see the finish line and you desperately want the home ready after a long wait, and frustration often boils over. I highly recommend hiring a professional home inspector to evaluate your home from top to bottom. Trust me; this is money well spent. Go through the inspection results and agree on one comprehensive list. Of course, additional things may come to light after closing. That is where the warranty comes in.
My best advice is to be organized, establish a realistic budget and stick to it and communicate clearly your expected timetables and finally, give the builder the space to do what’s needed. When it comes to inspection at the end, check for anything not completed or not completed as requested. The builder should rectify the issue. The key to working with a builder whether a development or custom, is to establish a realistic budget and stick to it, even when higher-cost options entice you. While most buyers realize that additional customization will increase the home’s price, unexpected costs can take you by surprise, so it pays to do your homework.
Do I Need A Realtor?
When you buy a new construction, the Builder normally has a sales office with representatives to help you view the model homes and answer all your questions. The sales rep is helping you, but not representing your best interest. The sales rep represents the builder’s best interest, not yours. The sales rep is highly paid to help you feel comfortable as you view the various floor plans the builder offers. You’ll get cookies, coffee, sodas and all kinds of treats so that you will feel at home. While they can draw up a sales contract, it’s important to understand; they do not represent YOUR best interests. Many new home shoppers don’t realize that you can have representation by a Realtor at no cost to you. That’s right; the Builder pays their commission! All the key builders have a pact with the Realtor community. They cannot lower their price if you use a Realtor. All you need to do is choose a Realtor to represent you and have them accompany you on your FIRST visit. Your Realtor will register with the Builder which solidifies that you have representation. For no cost, you will have help negotiating with the Builder and advice every step of the way through to the closing. Your interest comes first!
Here is a great place to start learning about new construction. RECOLORADO
Choosing Custom or Semi-Custom Builder
Planning for a new home can be a bit overwhelming. There are so many builders to choose. One of the biggest decisions you’ll find on this trek is whether to work with a smaller custom home builder or a higher-volume production or semi-custom builder.
Both types of manufacturers are great options, and each can deliver a beautiful new home for you. How many choices and how much design input during your home’s construction process will weigh heavily in your builder choice.
The difference between a production builder and a custom builder is relatively straightforward.
A production builder simultaneously builds many homes based on a limited selection of home plans. You will get to select from several options and personalize your home by selecting products such as appliances, cabinets, countertops and flooring. Most builders also offer variations in bedrooms, dining rooms or a study.
A custom builder typically creates a one-of-a-kind home that provides an even greater range of design choices and is built on a single lot. Buyers who wish to have a more distinctive home on a location of their choosing with a more hands-on approach will often select a custom builder.
The differences between custom and production builders will help determine what product and design choices you’ll make and also shape how you and your builder will work together.
In Colorado, particularly in medium to large cities, production builder’s account for most new homes built. In other areas more rural or mountain properties, custom homes comprise a much greater share of new homes. Here’s what you can expect from both builders:
Typically you’ll find two types of production builders: locally based/regional firms and national companies.
Locally based production builders construct homes in multiple new home communities in a particular city or region. National builders build hundreds or even thousands of homes per year in the major master-planned communities throughout the country. Both local and national builders typically offer 2 or 3 Series of homes in broad price ranges from low to higher priced plans. Within the Series, various projects are ranging from low to higher prices. Each Series also offers many options to choose from so that you can personalize your home.
Most production home builders:
- Offer home and land as a package. Better and larger lot locations add a “Premium” price.
- Offer a range of home styles, and elevation plans to choose.
- Allow you to select their distinctive style/designs from a menu in their “Series” products.
- Build homes priced for first-time, move-up and luxury buyers.
A production builder delivers the same size home for less money than a custom builder. The volume purchasing power when buying building materials and land with a systematized approach to construction make for a more affordable price.
Purchasing and zoning the right type of land is a big part of a production builder’s strategy. Many large developers construct homes in larger, master-planned communities. A production builder’s scale and access to a huge number of lots allow them to develop enormous neighborhoods and to fine-tune production for greater efficiency.
Higher volume builders can also pass on cost savings to you. They can use their size to order materials for hundreds of homes at a time, often at lower prices.
In addition to using size to generate cost savings, production builders are focused on quality. The top companies deliver carefully designed, highly engineered, solidly built homes with components and systems that are designed and optimized to work together. With up-to-date, appropriately sized heating and cooling systems, these new homes are much more energy efficient and comfortable than older homes.
An advantage of large new home communities is that the developer will often give careful thought to protecting open spaces. The developer may also provide an enticing array of community amenities – such as a clubhouse, fitness center, swimming pool, hiking trails, sports fields and more.
The community developer also works in close cooperation with each builder to ensure an attractive mix of homes. In addition to mixing models or floor plans from several builders, each home plan typically offers multiple elevations to vary the look of the front of each home. By changing the placement of windows, gables, and the size and shape of the front porch, a single floor plan is built for several different looks.
For further design appeal, each elevation has a differing type and color of the exterior. A model home can be constructed with various brick, siding, stone or stucco and varying shades of color to offer diversity and individuality.
As you work with a production home builder, you’ll typically start by selecting a lot for your home and your personal floor plan from the builder’s library of ideas. The next step is to choose an elevation. Many production builders also offer the opportunity to specify the use of a bonus room; based on your needs, a bonus room is an extra bedroom, a study or even a media room.
Now, you and the builder will work together (often in a design center) to further personalize your new home by selecting design options.
Manufacturers vary in their selection process. Typically you’ll pick your favorite style (such as contemporary or traditional) and your favorite colors and finishes for your home such as appliances, cabinets, countertops and carpet and flooring. In most cases, you’ll also select bath, kitchen faucets, sinks, and fixtures as well as lighting fixtures for your home.
If you choose a production builder, usually you cannot change the basic structure – the floor plan, the layout of rooms or square footage. Each model has a wide array of attractive options to choose from to personalize your home. Also, many builders offer a series of “good, better and best” options at similar price points to help simplify your product choices.
Most production builders work hard to make building a new home fun and exciting. In addition to model homes where you can experience the look and feel of the various rooms and options, many larger home builders also have a well-defined set of steps to help guide you through the steps to buy, design and build your new home.
If you have your eyes on a particular piece of land, want to build in an established neighborhood, already have a set of floorplans, or want to be heavily involved in each step of your home’s design, you may want to consider a custom home.
As the name implies, the process of building a custom home is less scripted than a production home, because there are no pre-defined choices or menus to select. With custom homes:
- You can build on land you own or land that you acquire.
- You can pay an architect to design a set of home plans from scratch.
- You can work with a separate architect and builder – or with a design and build company that manages both the design and the construction process.
- You’ll be more involved in the process and have the opportunity to make many decisions customize the home to your exact taste.
- You can pick from nearly any product within your budget rather than select from a defined menu of choices.
You’ll likely pay more for a custom home than a production model of similar size and floor plan. The typical custom builder does not have labor shortages that a production builder typically has. Your actual price will depend on many variables – the most obvious being the size of the home, the intricacy of its design, the building products and materials you select, and the land you purchase.
While you might associate custom homes with huge and expensive homes, a custom home can range from a simple ranch-style home to a more elaborate and multi-story floor plan designed around your lifestyle.
Since most custom builders create homes in a variety of architectural styles and price ranges, a great place to start when selecting a custom builder is to ask to see photos of the former homes they’ve built. Many custom builders maintain strong relationships with past homebuyers, so you should also be able to work with a custom builder to set up an appointment to visit a home they’ve previously built. Make sure to get references and reviews from the builder’s past clients.
Once you choose a custom builder, be prepared to select custom woodwork and nearly any type of appliance, flooring, and cabinetry. You will be able to choose most details of your home within the framework of your floor plan. You can work in close collaboration with the architect and builder to choose your home site and to design a floor plan that works around existing trees on your land and that places your windows to take advantage of your best views.
The main issues with building a custom home will be your budget and building code or zoning limitations. If you think that freedom to create a home from scratch will be exciting, then a custom home is likely for you. Just know that a custom home will consume a tremendous amount of time and energy – but the outcome will be worth it.
Equipped with the information above, you’re should be ready to decide if a production or custom builder is your best bet. A good production or custom builder will each deliver a high-quality home that’s personalized for you with much better energy efficiency and indoor air quality than a typical resale home.
The difference boils down to how many choices you’d like to make to determine the unique look and feel of your new home.
Understanding Your Warranty
Buying a home is the most expensive purchase you’ll ever make. Of course, you would be interested in a warranty if you have a new home built. Warranties promise to repair or replace individual elements of your home, if necessary, within a particular time. According to the Federal Trade Commission, if you’re considering a home warranty, it’s important to understand what it covers. You need to know how to make a claim and the process for resolving disputes between you and the builder, or Warranty Company.
The builder backs many home warranties; they purchase others from an independent company that assumes responsibility for claims. You may want to purchase additional coverage, on your own, from third-party warranty companies to supplement the coverage your builder provides. The Federal Housing Authority (FHA) and the Department of Veterans’ Affairs (VA) require you to purchase a third-party warranty as a way to protect your newly built home with FHA or VA loans.
Warranties for newly constructed homes offer limited coverage on work and materials relating to various components of the home such as windows, heating, ventilation and air conditioning (HVAC), plumbing and electrical systems for specific periods. Warranties also define how repairs are completed.
The duration of coverage varies depending on the components of your house. Coverage is provided for work and materials on most elements during the first year. For example, most warranties on new construction cover siding and stucco, doors and trim, drywall and paint during the first year. Coverage for HVAC, plumbing and electrical systems are two years. Some builders provide coverage for up to 10 years for “major structural defects,” sometimes defined as problems that make a home unsafe and put you in danger. For example, a roof that could collapse is a “major structural defect.”
Most warranties for newly built homes don’t cover expenses you may incur as a consequence of a major construction defect or warranty repair. For example, the costs of moving out of your home while repairs are made. They typically won’t cover:
- Household Appliances
- Small Cracks in Brick, Tile, Cement or Drywall
- Components Covered under a Manufacturer’s Warranty
- Making a Warranty Claim
What should you do if you have a defect in your home that may be covered by your warranty? First, read the warranty or service contract carefully to make sure that your problem is covered. Pay particular attention to the duration of specific types of coverage. Next, file your claim according to the instructions in your warranty, and put your request for repair in writing, even if the company provides a hotline for urgent requests. Request a return receipt, and keep a record of your correspondence and conversations with the builder. Chances are your claim will be handled amicably and to your satisfaction, but if a dispute arises, it’s good to have a record of your dealings with the builder and the warranty company.
Resolving Your Dispute
Occasionally, a dispute arises between a homeowner and a builder or third-party company over whether a defect is covered or whether repair work was done properly. Many warranties on newly built homes provide for mediation of disputed warranty claims, followed by mandatory binding arbitration. In mediation, a neutral third party — a mediator — helps you and the company resolve the problem by facilitating discussion between both sides. It is up to you and the company to reach an agreement.
If mediation fails to resolve the dispute, it is likely that you would be required to submit any claim to arbitration, instead of going to court. In this process, an “arbitrator” or panel makes a decision or award once you and the builder present their cases. Some warranties allow you to pick an arbitrator from a list acceptable to the builder or the third-party warranty company.
Arbitration is less formal than court, although you and the warranty company may appear at hearings, have legal representation, obtain documents from one another, present evidence and question each other’s, witnesses. Most warranties require that both parties abide by the arbitrator’s decision, without appeal. If your loan is with the FHA or VA and you file a claim against the third-party warranty company, you can choose between arbitration and court. If you accept arbitration, be aware that the decision binds you. More details are available from the FHA or VA.
Although arbitration is less expensive than going to court, you can expect to pay up to several thousand dollars to take your claim through the process, depending on the complexity of the arbitration. Read your warranties carefully to determine what arbitration costs or expenses you will be responsible for and what costs or expenses the builder must pay.
A few companies offer homeowners the choice of arbitration or going to court. Sometimes builders pay all costs associated with arbitration to encourage you to agree not to take the matter to court.
For More Information
To learn more about warranties on newly built homes, contact your state or local builders’ board. If you have a loan insured by FHA, contact the closest U.S. Department of Housing and Urban Development field office for more information, or visit www.hud.gov. If you have a VA loan, you can contact the nearest VA office, or visit www.homeloans.va.gov.
You’re fed up with renting, want to upsize your home to accommodate a growing family, relocating for a new job, downsizing or are planning for your final retirement home. These are all great reasons to consider a new construction.
You might be worried. Can I qualify for a home loan? Many first time home buyers give up before even trying. The truth is, there are many types of mortgages, grants and down payment assistance programs available. Even if you are facing financial challenges, a mortgage broker or loan officer can help you determine which home buying loan program is right for you.
PREPARING FOR A NEW HOME LOAN
YOUR FINANCIAL SITUATION
One of the best things you can do to prepare for the home buying process is to check your credit rating. The three major credit bureaus: Equifax, Experian, and TransUnion will typically provide your overall credit score. You’ll want to clear up any errors that may appear on those reports as soon as possible. You should also consider consolidating any debt you may have. The goal is to have your total debt less than 38% of your total income. Your credit score is an important factor in determining how much you are qualified to borrow, so make sure you do your homework and find out where you stand.
Mortgage lenders prefer to lend to borrowers who have worked for the same employer for at least two years. For first-time buyers, this can often be a problem: Many first-timers are young professionals who are still building their careers and may have to move from job to job at a quick pace. Fortunately, most mortgage lenders are flexible on the employment issue. Many will overlook a short job history if borrowers can show that they still have a steady source of income that is high enough to cover their mortgage loan payments comfortably.
Being self-employed is a much more complicated. You will be required to show evidence of continued ability to earn income for a sustained period and be able to continue to make and build those earnings in the future. Lenders will scrutinize every facet of your business and if you are in good standing with the IRS.
LESS THAN PERFECT CREDIT?
Good credit is ideal, but we all know that unfortunately in this market many of us don’t fall into that category. The good news is that there are many types of mortgages for those with not-so-perfect credit, and chances are you may still be able to qualify for home financing.
Before you begin to look for a home, your first step must be to get preapproved. The preapproval will give you the confidence to look for a new home, know how much you qualify to borrow and better understand your different home financing options. Having a preapproval will alleviate much of your stress. Now you need to choose. Who will get you preapproved?
MORTGAGE BROKER OR LOAN OFFICER?
Typically a large production builder will have a preferred lender. They will often offer an incentive to use their bank. But, will that motivation lead to the best mortgage terms for you? You may find that getting your lender, may offer better terms than the incentives afforded by the builder.
Finding and choosing a qualified and competent Mortgage Broker or Loan Officer is important, especially for a first-time mortgage. A Mortgage Broker is an independent licensed agent that works to find the best lending terms and rates within an assortment of lenders that best fit your risk factor. Your risk factor determines your credit score, income, and many other factors. The Broker will be paid by the lender you choose. A Loan Officer works for a bank or company that directly provides mortgage funding. Whoever you decide to work with will come to know a lot about you, and will be involved in one of the biggest decisions you will ever make. It’s important that they are trustworthy, make themselves available to answer your question and are knowledgeable on all the different loan products available.
Be ready to provide documentation for all of your finances, including proof of income (paystubs), copies of W-2s, and copies of asset information. Your lender will help you prepare, so you’ll be confident about your decision to buy a new home and relieve any fears about the process. You will be educated on the different type mortgages available and go through the preapproval and final approval process.
Buying a home for the first time can prove to be a challenging task. First-time buyers often don’t know the meaning of real estate and mortgage terms. The amount of paperwork needed to close a mortgage loan sometimes overwhelms them. And the sum of money they need to put together to purchase a home can be intimidating. First-time buyers, though, can make the process less stressful by understanding and recognize some of the more common challenges that novice home purchasers face.
WHAT TYPE OF LOAN IS BEST FOR YOU?
There are several types of loans available to buyers, such as fixed-rate mortgage, adjustable rate mortgage (ARM), FHA mortgage, and Veteran’s Affair (VA) mortgage.
A Fixed-Rate Mortgage is a mortgage where the rate of interest is fixed for the duration of the loan. These loans come in 10-, 15-, 20-, and 30-year durations. The shorter the length of the loan, the higher your payment will be, but the time to pay off the loan will be shorter, and the amount of interest paid will be less.
An ARM is a mortgage where the interest rate adjusts throughout the loan period. People tend to want these types of credit when they want a lower payment now and do not care if the amount goes up later because they will have a higher income to pay for the loan. With this type of loan, you could afford to buy a higher priced home now instead of later. But, beware because the interest rate could jump as much as 2 percent in a given year depending on the stipulations of the loan and economic conditions.
An FHA Mortgage is not a credit but a program sponsored by the federal government to encourage homeownership. The FHA will provide assurances of payment on your behalf to lenders that would otherwise not approve you. Meaning that if you do not pay the loan, FHA will step in and pay it to the creditor, but in turn, they will take your house from you. When you have an FHA loan, you need to pay PMI as part of your monthly payment because it is usually less than 80 percent LTV. That is how the FHA will cover the lender in the event you default on the loan. The cost of PMI will vary with the outstanding loan amount each year and is only payable until the loan reaches 80 percent of value. In some cases with an FHA loan, your down payment can be a little as 3 percent of the price of the home. You do have to apply to the government, and there are usually some income restrictions.
A VA mortgage is a loan given to any person and eligible spouses who have ever served in the military. Private lenders provide VA Home Loans. VA guarantees a portion of the loan, enabling the lender to provide you more favorable terms (http://www.benefits.va.gov/homeloans).
COSTS ASSOCIATED WITH YOUR PURCHASE
Buying a new home requires a few different up-front costs. Be prepared for what you will spend on a new home by understanding why and when you’ll need to have cash ready:
Earnest Money: Money you put up front to show that you’re serious about purchasing.
Down Payment: Money that’s paid toward the total of the home’s price, usually 5-20%, but you can get it as low as 3% if you qualify for certain types of mortgages. Saving money is a top priority for a home buyer. Saving as much as you can or having equity in your current home will ensure a substantial down payment and the potential to lower your interest rate and monthly payment. Almost all home loans require a down payment somewhere between 3% and 20% of your home’s purchase price. The down payment is typically the largest cost of your home purchase, especially for buyers looking for a first time mortgage. Providing this much cash must be taken seriously, and you need to start saving if you’re going to buy the home you want.
HOW MUCH SHOULD YOU PUT DOWN?
The amount of money to put down depends on your particular situation and loan you choose. Some loans require that you pay a higher down payment than others. For example, you can get a Federal Housing Administration (FHA) loan for 3–4 percent down, while a conventional loan usually requires a minimum of 20 percent down. A couple of things to keep in mind is; if your loan-to-value (LTV) is less than 80 percent, you will be required to pay “private mortgage insurance (PMI)” as part of your monthly payment until the Loan to Value (LTV) reaches 80 percent. My recommendation is that if you have the money available for a down payment, use it to avoid paying interest in the long run and avoid paying the PMI.
Another option is to get two loans, a conventional loan for 80 percent of the price which will be long term, and a shorter term loan which will be your 20 percent down payment. This option is recommended if you are waiting for money from the sale of another home or another asset.
Gift monies can also be used to purchase a home. If you are planning a wedding, it is not uncommon to find wedding registries that include cash gifts to help you plan for a home purchase.
If you are currently a homeowner and are selling your home, the equity or net sale from your home sale can provide the required down payment or more.
Closing Cost: Expenses associated with a home loan, such as processing fees charged by the Lender, Title Company, the local government and anyone else involved with the home sale. The lender is required to provide you with a “Good Faith Estimate” (GFE) which gives you an estimate of all the closing cost fees ahead of time.
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Alternative Ways to Finance Custom Built Homes
If you choose to go with a custom home construction, financing gets much more challenging. Typically a custom home builder is smaller, and the financing must be procured by you the buyer. There are custom builders that have a cooperative arrangement with a lender. If you have to go it alone, this is what you can expect.
A New Custom Home Construction Can Get Financed in Three Ways.
- The builder finances construction, and when the house is complete the buyer obtains a permanent mortgage.
- The customer gets a construction loan for the period of construction, followed by a standing loan from another lender, which pays off the construction loan.
- The client obtains a single combination loan, where the construction loan becomes permanent at the end of the construction period.
Builder financing is the simplest approach with significant advantages to the buyer, including not having to worry about the builder’s financial capacity or the complexities involved in the alternatives discussed below.
Separate Construction Loans and Permanent Mortgages
The obvious downside of two loans is that the buyer shops twice, for very different instruments, and incurs two sets of closing costs.
Construction loans usually run for six months to a year and carry an adjustable interest rate that resets monthly or quarterly. The margin will be well above that on a permanent ARM. In addition to points and closing costs, lenders charge a construction fee to cover their costs in administering the loan. (Construction lenders pay out the loan in stages and must monitor the progress of construction). In shopping construction loans, one must take account of all of these dimensions of the “price.”
Some lenders (primarily commercial banks) will only make construction loans. Others will only make combination loans. And some will do it either way.
Note: Interest on construction loans is deductible as soon as construction begins, for a period up to 24 months, provided that at the end of the period you occupy the house as your residence.
The permanent loan is no different from that required by the purchaser of an existing home, or by the buyer of a new house on which the builder financed construction. Indeed, the advantage of the two-loan approach about the combination loan discussed below is that the purchaser retains freedom of action to shop for the best terms available on the permanent mortgage.
Combination Construction/Permanent Mortgages
The major talking point of the combination loan is that the buyer only has to shop once, and has to pay only one set of closing costs. The danger, however, is that the buyer will overpay for the permanent mortgage because the arrangement has limited his options.
Lenders offering combination loans typically will credit some of the fees paid for the construction loan toward the permanent loan. The bank might charge 4 points for the building loan, for example, but apply 3 of the points toward the permanent loan. If the borrower takes the permanent loan from another lender, however, the construction lender retains the 3 points. It ‘s hard to compare combination loans with the two-loan alternative.
For example, suppose the buyer wants to compare the cost of the construction loan offered by the combination lender cited above with an independent construction loan offer at the same rate plus 2 points. The buyer can get the construction loan for 1 point provided he also takes the permanent loan, or for 2 points while retaining his freedom of action to shop for the best deal on a permanent loan. Which is the better deal depends on how the combination lender prices the permanent loan with the competition.
This is not easy to determine. While you can compare current price quotes on permanent loans by the combination lender with quotes from other lenders, these don’t mean much. The actual price is set after the house is complete, and at that point, the combination bank has an incentive to overcharge. In my example, he can over-charge by up to 3 points, because that is the amount he retains if the buyer goes elsewhere.
You should not take a combination loan unless A) the current combination price quote is at least as good as the best quotes from separate construction and permanent loan lenders. B) the combination bank is willing to index the price of the permanent loan so that you know exactly how it will be when the time comes.
If the combination bank insists that you will get the market price, it is time to bail out and go with two loans.