Big Dreams, High Dollars: Financing Your Dream Home
We have all browsed through home magazines featuring luxurious dwellings, and many of us dream of someday building our own or even renovating what we have. But it takes funding—usually lots of it—to make this dream a reality. Financing a home, whether a new custom home or a large-scale renovation, is a process that requires thought, preparation and good contacts with financial institutions.
Securing funding can be stressful, especially if you dive in unprepared without some understanding of the process. Since the avenues necessary to borrow money are almost as diverse as how the money is spent, it is very important to understand all of your lending options. Know how much you expect to borrow and how you can pay it back. Then go to your local bank, credit union or specialty financial service company to learn about the types of financing they have to offer for your particular project.
Financing a Custom-Built Home
Once homeowners find a piece of land and the design for that perfect house, they enter into what is perhaps the most important phase of the project—its funding. Finding an institution that will provide the necessary loans takes time. Keep in mind that securing funds for a custom-built home is more involved than funding a tract home. According to Linda Lynch, who with her husband Reggie just moved into their custom-built home in Forest, the process of securing funds took about as long as it did to complete the house: five months!
Look for lenders who specialize in construction financing. This may take longer than it would to find financing for an existing home because of the specialized nature of the loan. Your general contractor can often provide resources for financing the actual construction portion of the project.
The Bank of the James considers a construction loan for a custom home as a two-part process. According to the bank’s Garth Calhoun, “Before we begin the ‘construction’ financing, we have someone from our mortgage department talk about the financing that will be needed after construction is completed. [This department] will gather income information and other financial documents and look to get the customer preapproved for the mortgage. After approval, we’ll use the same documents to look to approve the construction loan.”
Reggie Lynch advises that when seeking a loan, a homeowner should plan to offer at least a 20-percent down payment. This avoids the monthly PMI costs. (PMI, or private mortgage insurance, is extra insurance that lenders require from most homeowners who obtain loans that are more than 80 percent of their new home’s appraised value.)
“A borrower’s financing options are typically driven by the amount of equity and cash they have in the transaction, their appraisal, their income and employment, their assets and reserves, and their credit score,” explains Bill Herbert of First Bank & Trust Company. Depending on each borrower’s situation, Herbert tries to customize the financing. Hence it is important that the lending institution has all the necessary information about the borrower and the proposed project.
Today borrowers must be prepared to answer many questions and expect credit checks. And do not be surprised if the lending institution requests to see copies of your tax returns.
Rick Comar of Select Bank compares the process to an interrogation, but this should not sway would-be borrowers. Just be prepared for that day when you apply for financing. Rick suggests the following tips:
- Pay bills on time.
- Do not open any new accounts or make any large purchases.
- Keep your credit card balances below 50 percent of your credit limit on that card.
- Do not close out credit card accounts. (If you close out the account, you eliminate that credit history and available credit.)
- Make sure that you can document all deposits into your asset accounts.
- Don’t quit your job.
- Keep your income and asset information together and organized.
A great deal of documentation is required for construction loan approval—far more than is required for a standard mortgage. Remember, the home does not exist yet! The lender must review plans and budgets which hypothetically value the home based upon assumptions provided by the house plans. The lender also must be sure that the borrower will qualify for permanent financing once the construction phase is completed.
Construction lenders rarely provide all the funds for a construction loan immediately. Instead, they pay out the loan in multiple periods as each portion of the construction project is completed. The first installment may pay for the purchase of the land, if it is not already owned. The loan should outline the number of draw periods and the requirements for each. The next draw is contingent upon the successful inspection of the work or other documentable benchmark. The borrower will pay interest only on the amount the contractor draws as the house is being built.
Experts recommend that homeowners then apply for the previously approved permanent financing between 30 and 60 days prior to completion of the home. Some lenders permit the homeowners to refinance the construction loan, instead of treating it as a purchase mortgage. Refinance mortgages do not usually require a down payment. Purchase mortgages do. This allows the homeowners to use the equity built in the home, rather than requiring an additional five-percent-or-more down payment that is typical in a purchase mortgage.
Research your lending options before choosing a construction loan company. According to Bill Herbert, “Community banks are the only ones that consider construction loans.” Herbert recommends that homeowners look to their contractors for guidance when selecting a bank. Contractors are familiar with the local banks and usually have developed good working relationships with individual institutions. These relationships are built on mutual respect, and these contacts will often yield favorable results when homeowners are seeking funding.
Financing a Home Renovation
Perhaps building a new home is not in your plans. You love your current home and its location, but envision a few changes that would make it perfect. A renovation might be just the answer.
It is important to consider the size of your project and how much you need to borrow before choosing a type of financing for a renovation. Whether it is building an addition or giving a room a facelift, renovations usually increase the resale value of your home. Consider the amount of money necessary for the project. How much is needed up front? Or is the money needed in stages as portions of the project are completed?
The first step is to get preapproved by a lender. Then talk to your contractor and make sure that the budget is at least ten percent less than the lending institution has approved. (This is in case there are additional costs later on in the project.)
Refinancing your mortgage is an option if you have already built some equity in your home and you are planning a major renovation. Depending on the terms, the monthly mortgage payment might remain the same, and only the length of the loan may be extended. If the renovation is something structural, lenders may approve the loan based on the projected value of your home after the project is completed.
A home equity loan works somewhat like a conventional first mortgage. A lump sum is borrowed and payments are amortized over several years. Usually the interest rate and monthly payments remain fixed throughout the term of the loan. This option requires an additional payment on top of your first mortgage and usually carries a higher interest rate than a refinanced mortgage. Closing costs may be lower, and if you need the money all at once, this may be the loan option that is best.
According to Bill Herbert, financing a renovation is affected by a borrower’s equity position before and after the project. “For a large renovation, we would treat the financing somewhat like a regular residential construction loan.” For a smaller project, a second mortgage product such as a home equity loan or home equity line of credit (HELOC) would be a good option. In some cases, a HELOC may be more beneficial for a home renovation project. Unlike a fixed-rate equity loan, a HELOC allows the borrower to obtain an approved “limit” which allows funds to be withdrawn as the project progresses, only paying interest on the advances taken. A HELOC is a good choice if you will be paying for your project in stages. The lender agrees to advance money up to a specified limit and you access the money as needed with a credit card or checkbook. The lender establishes a credit line which is similar to the borrowing limits on your credit card. You can write checks for any amount up to that limit as you need it.
A second mortgage is a separate loan from your original first mortgage that is tied to the property in second lien position. A borrower will use equity in the property to obtain a loan secured by the primary residence. Equity is the difference between what a borrower owes on a property and what the value of that property is worth. A second mortgage can be paid back in fixed-rate programs such as a 5-, 10- or 15-year amortization. The interest on these loans may be deducted from your taxes, but be sure to consult your tax advisor in this scenario.
The federal government offers renovation loans, but the application process can be complicated. According to Rick Comar, they are time-consuming and difficult to complete. For more information on what the federal government has to offer, check out their website at www.hud.gov.
A personal line of credit works for a small project. The fees to set these up can be lower, but since they are not secured with your home, they carry a higher interest rate and they are not tax-deductible.
Homeowners have many options for financing home projects, but you have to do your homework. If you’re seeking a renovation or new construction, make sure that you know the contractor and if he is qualified to do the work. Your local home builders’ association can provide names of qualified builders in your area. Comar recommends would-be borrowers work with a loan officer who has experience. Organize your income and asset documents. Find out first what size loan you qualify for before finalizing any home building or remodeling plans. With these preparations, you’ll be well on your way to the home of your dreams.
Special thanks to the following lenders who provided their expertise for this article:
Garth Calhoun, Bank of the James;
Rick Comar, Select Bank;
and Bill Herbert, First Bank & Trust Company