Dear Real Estate Adviser,
I want to build a new home, and the builder wants me to get a construction loan. I don’t fully understand what that is. Can you tell me the pros and cons of this type of loan?
— Diane F.
It’s the type of loan that is most convenient for the builder — but not always for the buyer. You would finance the cost to construct the house rather than buying a house that’s already been constructed by the builder. These are often called “story loans” because your lender will want to get a very thorough construction-plan narrative and timeline before it will approve funding. Lenders are not a big fan of fiction, by the way.
But such construction loans can be tough to acquire for individuals these days. For peace of mind, I’d put the onus on the builder and ask him to carry the loan. That way, the contractor or design-build firm gets your design, you OK it, he builds it and you don’t have to take possession until it’s completed to your satisfaction. The builder is more motivated to finish work on time this way.
Either way, make sure your builder checks out. Ask for references, check with the attorney general’s office, obtain a credit report, and check for lawsuits and outstanding liens. One home inspector friend of mine says you should go to city hall and check with a few customers not listed as references. Their names will appear on building permits.
If your builder won’t agree to handle the loan and you decide to carry it, here is what will happen. Funds are typically disbursed in stages as the project progresses, a process that can be a hassle for an individual. You will be required to make only interest payments during construction, which will probably be at a higher rate than the rate on your permanent mortgage — a home loan that will kick in only after the project is completed.
You will want to get the place livable and exit from the construction-loan phase as soon as possible. Many lenders require that a certificate of occupancy be issued before they will finance the permanent loan. Lenders typically allow for overruns and changes as construction progresses via a reserve account. Unused overages are simply credited back after the house is finished, while outstanding shortages are added to the loan balance.
Beware! Anything not in the initial contract will cost you extra. Builders are always looking for add-ons and their ensuing markups, which are huge profit centers for them.
You should know that one of the most common complaints we hear about new-home construction is that construction typically takes longer than planned and usually comes in over budget. If you obtain the construction loan, I suggest you structure your contract to call for a late-completion penalty that the builder would pay by assuming a chunk of your interest payments.
Do your homework and negotiate everything. And be ready, by the way, to show up at the construction site at every major phase of construction to make sure you are getting everything you paid for.
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