Financing a dream home designed just for you doesn’t have to be a nightmare. In fact, lenders experienced with the custom home process say borrowing money to fund your perfect home, while it does require a couple of extra steps, is similar to financing any home purchase.
“The minute you think about building a home, you should meet with a lender,” says Rick Scott, director of construction lending for Silverton Mortgage in Atlanta. “Before you do anything else, you need to know what you can afford and how much cash you’ll need.”
Custom home financing requires a little more work, says Claudia Mobilia, senior vice president of operations for Embrace Home Loans in Middletown, R.I., including a review of your contract and approval of your builder.
“There’s a perception that custom home financing is complicated, but it doesn’t have to be,” says Nicole Wolfram, vice president of construction lending for Waterstone Mortgage in Pewaukee, Wisconsin. “You just have to make decisions upfront and stay in communication with your builder and your lender throughout the building process.”
First, buy land and find a builder
If you already own a lot and know you can build on it, you’re ready to pick your builder. If you need both land and a builder, you can choose between a lot located in a subdivision and a private lot. Either way, you and your lender will need to know whether public utilities are available or a septic system can be installed. You’ll need a loan preapproval to meet with a builder to develop plans and to ensure the house you want can be built your preferred lot.
Learn about closings, contingency funds and custom financing
Two common types of construction financing are single-closing loans and two-closing loans.
“A single-closing loan works just like buying any newly built home,” says Kim Newby, senior vice president of product development for Waterstone Mortgage in Pewaukee, Wisconsin. “The borrower qualifies for the loan, locks in the interest rate and pays one set of closing costs.”
While custom home loans usually require interest-only payments during construction, borrowers must qualify for the loan based on the full payments of the permanent loan. When the house is complete, borrowers only need to sign a modification form to convert the construction loan into their permanent financing, also called an “end loan,” says Newby.
Many lenders offer an interest rate guarantee for a one-time closing construction loan. Borrowers are charged a slightly higher interest rate, often about one-half percent higher than current mortgage rates, says Scott, so they know their mortgage rate won’t go any higher. If rates should drop, Silverton floats down the rate to the market rate.
While reducing the paperwork to one loan approval and charging only one set of closing costs make a one-time closing appealing, Scott says the disadvantage of these loans is that you can’t change the loan amount or the loan type after the initial closing.
With two-closing financing, borrowers take out a construction financing loan, closing on that loan before the house is built, says Catherine Holtman, operations support manager for Embrace Home Loans in Middletown, R.I. When the home is complete, the buyers must apply for a new loan for their permanent financing, have another appraisal and pay closing costs again.
“A two-closing loan gives buyers flexibility because they don’t have to choose their permanent loan program such as a 30-year fixed-rate loan or an adjustable rate mortgage until the house is complete,” says Scott. “Buyers can also adjust the permanent loan amount, which can be helpful if change orders or unforeseen circumstances drove up the cost of the home.”
A disadvantage of two loans is that they’re more expensive because of the requirement for two loan approvals and two closings, says Scott.
“Two loans are also riskier because you have no idea what interest rates might be when you apply for the second loan,” he says. “If interest rates jump from four percent to six percent or there’s some other change in your circumstances, it’s possible you won’t qualify for the permanent loan.”
Some borrowers must take out two separate loans if they can’t qualify for a single-close loan, such as if they’re paying a mortgage while building their next home. If you don’t qualify for a one-time closing loan and don’t want the risk of two separate loans, you can sell your current home and rent while having a home built to make it possible to qualify.
Lenders and borrowers typically plan for expenses such as lighting, flooring, cabinets, appliances and plumbing fixtures with an allowance such as $3,000 for lighting or $15,000 for flooring.
“We address this before the loan closing to make sure the allowances are adequate, but if a borrower goes above the allowances, they either have to change the selection or pay cash for it,” says Wolfram.
In addition, borrowers can sometimes qualify for a “contingency reserve” which Wolfram says is like a slush fund to pay for unforeseen costs.
Loan qualifications for custom homes
In general, loan qualifications for a custom home loan are similar to other loan requirements, but since lenders are taking on a little more risk, they will require extensive information about the house plans, the builder and your finances.
“Custom home lenders are loaning money based on collateral that hasn’t been built, just on vacant land,” says Wolfram. “That’s why we need to see the plans, the construction contract and even the list of materials to be used so we know what we’re lending on.”
Most lenders require a minimum FICO score of 680 or 700 for a construction loan. Your debt-to-income ratio, which compares the minimum monthly payment on all recurring debt including your housing payment with your gross monthly income, typically needs to be under 45 percent. Borrowers with limited cash reserves or a credit score under 740 may sometimes need a lower debt-to-income ratio to qualify, while buyers who make a bigger down payment and have more cash on hand may qualify for a higher debt-to-income ratio, says Mobilia.
Down payment requirements for construction financing vary by lender, with most requiring at least 10 percent and some, like Waterstone Mortgage, as low as a five percent.
Jumbo loan borrowers, whose loan amount is above the conforming loan limit set by Fannie Mae and Freddie Mac, which is $484,350 in most markets and $726,525 in high-cost housing markets in 2019, may need to meet additional requirements.
“Jumbo loan borrowers usually need a higher FICO score and additional cash reserves, but we allow down payments as low as five percent on jumbo loans,” says Newby.
When you plan to build a custom home, it’s important to choose the right builder, review contractor quotes and research the materials you plan to use, says Mobilia.
“It’s very important to get the fine print details settled in the beginning because it’s much harder to change things midstream,” she says.
Once you’ve fine-tuned your plans, the financing for your dream home can be simpler than you think.
Michele Lerner is an award-winning freelance writer, editor and author who has been writing about real estate, personal finance and business topics for more than two decades.