Building a custom home is such an exciting opportunity! Instead of settling for something that’s just okay, you get to create something extraordinary—a home built around your lifestyle and needs.
If you’re planning a project like this, you likely have many questions, including: Do I get pre-approval first? What type of loans are there for custom builds? How much should I budget for? What are the costs associated with custom builds? In this article, we’ll take you through the process of financing a new construction home, from planning a budget to the post-construction/closing phase.
Plan Your Budget
You’re probably ready to start dreaming and planning your new home, but it’s critical to establish a realistic budget before you talk to a builder.
First, estimate the monthly mortgage payment you’re most comfortable making. To do that, create a budget that includes your monthly expenses and income. Financial experts typically state you shouldn’t spend more than 28% of your gross monthly income on your mortgage payment or more than 36% on combined debt, known as the 28/36 rule.
Then, determine how much you want to spend on the down payment. The larger your down payment is, the less you need to borrow for a loan, and the lower your monthly mortgage payment will be. Lenders typically require between 3.5% and 20% of the home’s purchase price as a down payment. Building a custom home is generally considered a higher risk than standard homes, so lenders may require a higher down payment. If you already own a lot that the custom home will be built on and have equity in it, you can use some of this as part or all of the down payment.
Once you’ve determined your limit on monthly mortgage payments and how much you’re willing to spend on a down payment, you can use a mortgage calculator to test different loan and down payment amounts to determine monthly mortgage payments. This can help you understand how much you can spend on a new home.
Financing a new home can be overwhelming, but this type of homework is critical. It’s also important to remember that your banking institution or credit union can help you understand what your spending limits are.
Summary:
- Determine the amount of money you’re willing to pay monthly on a home.
- Determine how much cash you’re willing to put upfront for the construction of your home (down payment).
- Talk to your banking institution or credit union if you need help planning your budget.
Get Pre-Approval
Once you’ve done budget planning, you can request pre-approval from a lender. This could be your banking institution, credit union, or another lender.
Getting pre-approved before you build a home is recommended for two reasons: 1) Your building partner will feel more comfortable working with you as they will see you have the financial backing needed to complete the project, and 2) You can’t start the loan application process without pre-approval from a lender.
Pre-approval is a relatively straightforward process. Your lender will look at your credit score and history, current income, and debt to determine the amount you can borrow, the required down payment, the type of loan best suited for you, and APR (loan interest rate). Getting a fixed APR is critical here, as APR will influence your monthly payment amount. Some lenders may allow you to lock in an interest rate at pre-approval (depending on which loan you plan on applying for), so you don’t have to worry about that rate increasing during your project.
Generally, the higher the credit score, the better. Credit history provides insight into your reliability in managing and repaying debts, so if you have an excellent credit score, you will more likely benefit from lower interest rates. Investing in a larger down payment can also result in better interest rates and lower monthly payments.
Keep in mind the pre-approval will expire. Expiration dates vary on the lender—most are 90 days, but some lenders may provide 30- or 60-day pre-approvals. With that in mind, as you’re going through the pre-approval process, it’s not a bad idea to research licensed custom home builders.
Summary:
- Pre-approval is based on credit history, current income, and existing debt.
- Higher credit scores, steady income, and low debt are essential for lower interest rates and monthly payments.
- Pre-approvals only last up to 90 days.
- Start researching for builders while you’re going through the pre-approval process.
Find a Builder
The next step is finding a licensed builder. Lenders will start the loan process once you have a contract and project plans with a builder. Additionally, lenders do not accept just any construction company. If you’ve found a lender you love, you can ask them for a preferred list of builders and start your research there, or if you’ve already selected a builder you want to work with, you can ask them for their list of preferred lenders. You don’t need to take out a loan at the same institution where you received pre-approval. Once you have pre-approval, you can start the loan process with any lender.
Once you find a builder you’re interested in working with, you’ll need to discuss your project with them. Your building partner will want to know:
- Your targeted (pre-approved) budget
- Your preferred location and if you already own land
- Any timeline restrictions or requirements
- Design preferences (including size and layout)
- Essential home features
They may also ask about the lender you’re working with or provide recommendations if you’re still looking for one.
After you’ve signed a contract with your home builder and chosen a lender, your home builder is responsible for providing the following information to your lender:
- A detailed project plan that includes blueprints, designs, and specifications
- A cost breakdown and budget
- Construction timeline
- Land information (if building on a new plot), including purchase price, location, size, zoning regulations, and any existing liens or mortgages on the property
- Building permits and approvals
- Proof of insurance and licensing information
- Warranty information
- Subcontractor information
- Lien waivers
- Inspection and appraisal reports
- References and resume to establish experience
If your building partner was recommended to you by your lender, they may not need to provide references or any additional information to establish their qualifications and experience.
Summary:
- Consult with a builder to get the project details you need to start the loan process.
- You don’t need to take out a loan at the same institution that granted you pre-approval.
- You can find a builder through your preferred lender or find a lender through your preferred builder.
- When you sign a contract, the builder will provide the project details and documentation needed to start the loan process.
Understand Your Loan Options
There are several types of loans you could apply for. Your lender will review these options and determine which is best for you based on your financial needs and project details.
It’s a good idea to know what to expect heading into this process—applying for a loan is relatively straightforward, but receiving the loan can take a long time, sometimes even more than a month. This is especially true with construction loans, which are a bit more challenging than traditional mortgages.
Qualifying for a construction loan is typically more challenging because:
- New home projects are considered riskier to lenders because the home is not yet built, and if issues arise during the project or if the finished home doesn’t end up being worth as much as expected, the lender faces higher risks.
- This increased risk means lenders may have more strict qualification criteria, including higher credit score requirements (at least 680), lower debt-to-income ratios (43% or lower), and higher down payments (sometimes 20-30% of the total project cost).
- You need detailed project plans and proof of land ownership or an acquisition plan.
Construction loans typically have variable interest rates, too, which can fluctuate during the construction period.
The process may be more straightforward if you work with one of the lender’s preferred builders. The lender and builder already have an established relationship, and the lender knows that the builder is reliable.
Let’s break down some of the most common loan types:
Construction-to-Permanent
A construction-to-permanent or single-close construction loan allows you to obtain one-time financing to fund the home’s construction. It then converts into a permanent mortgage. During construction, it operates as an interest-only loan.
Construction-Only
A construction-only loan is a short-term loan that only covers the costs during the construction period. With a construction-only loan, you would also need to apply for a traditional mortgage or refinance the construction-only loan into a traditional mortgage after construction is complete.
Land
Land loans are loans used to purchase the land on which the property will be built. The qualifications are similar to construction loans but will vary based on the intended use of the land (personal use, investment, future construction, etc.). For example, the qualifications may be more relaxed if you plan to construct a home on the land you want to purchase immediately. It’s important to know that land loans often come with shorter repayment terms and higher interest rates than traditional mortgages.
End Loan
An end loan is a traditional mortgage. It’s called an end loan because it is the loan that “ends” the construction process, paying off a construction loan (if one was used) and providing long-term financing. Lenders will typically not finalize a traditional mortgage until construction is complete and the home is appraised. End loans are not required in construction-to-permanent loans.
Several end loan types exist, like conventional, FHA, and VA.
Most of the qualifications for a traditional mortgage are similar to construction loans, except that project plans and builder documents are not required. Credit score qualifications may not be as strict—the exact score requirements will vary by the lender and type of end loan.
Conventional Mortgage
As the name implies, a conventional mortgage is the most common type of traditional mortgage. Unlike FHA or VA loans, conventional mortgages don’t have the backing of a government agency. Conventional loans can be offered at fixed and adjustable rates over various time frames, including 15, 20, and 30 years. If you pay less than 20%, you must pay PMI, or private mortgage insurance, which protects the lender in case of default. The PMI will eventually be removed once you achieve 20% equity in the home.
When you apply for a conventional mortgage after the construction project, everything will be reassessed, including your credit score, debt-to-income ratio (DTI), and current employment situation. The good news is that qualifications for conventional loans are typically more lax than construction loans. Most lenders will accept credit scores of at least 620, but the sentiment remains the same—the higher the credit score, the better. Your debt-to-income ratio should still be at least 43% or lower, although some lenders may accept a 45 or 50% DTI. Lastly, down payments may not be necessary if the construction loan covers the entire cost of the construction and property. If it didn’t, you would need to make a down payment on the conventional mortgage, which can be as low as 3.5% of the home’s value.
FHA
An FHA loan is a government-backed option for first-time home buyers with lower credit scores and smaller incomes. Like all loans, proof of steady income and a reliable employment history are vital. However, credit scores can be as low as 500. Down payment requirements will vary based on credit score—typically, the lower the credit score, the higher the down payment. Mortgage insurance is required, regardless of how high the down payment is. There are limits on how much you can borrow with an FHA loan that will vary based on location—your lender will help you decide if this is a viable option.
VA
You can apply for a VA loan if you are an eligible American veteran or the surviving spouse of an American veteran. This loan type offers significant benefits, including no down payment or PMI, and limited closing costs. Qualifications will vary based on the lender, but generally, you would need to provide a certificate of eligibility (COE) from the VA, proof of stable income and reliable employment history, and have a credit score of at least 620 or higher and a DTI of 41% or lower. The one challenge is that the VA requires new construction homes to meet specific standards and be backed by a one-year warranty—please let your builder know if you plan to apply for a VA loan.
Summary
- Construction loans require higher credit scores, lower debt-to-income ratios, and higher down payments.
- Comprehensive project plans/details, an appraisal, and proof of land ownership or an acquisition plan are required to qualify for a construction loan.
- After the construction process is complete, there are several end loan/refinancing options for homeowners. These include conventional mortgages, FHA loans, and VA loans.
- There are unique construction and warranty requirements for VA loans, so let your builder know at the beginning of the process if you plan to apply for a VA loan.
- A lender can help you decide which loan options are best suited for you.
Gather Documentation to Start the Loan Process
Documentation Needed for Construction Loans Only:
- Project details (including blueprint, project budget, and estimated timeline)
- Contractor’s license and insurance information
- A signed contract with the builder
- Builder’s resume (may not be required if you are using one of the lender’s preferred builders)
- A copy of the deed and proof of equity in the land you own OR a purchase contract and market appraisal of the land you are purchasing
Documentation Needed for Construction Loans & End Loans:
- Government-issued photo ID
- Social Security card or number
- Recent pay stubs
- W-2 forms and tax returns for the past two years (minimum)
- Bank statements (not needed if your lender is your banking institution)
- Documentation for other assets like personal property and real estate
- Credit report (the lender will obtain this for you—you will need to authorize the hard inquiry)
- Debt information (car loans, student loans, etc.)
- Rental history (if you rented property before building your home)
- A home appraisal
- The purchase agreement of the home
Some lenders may also require that you purchase a homeowners insurance policy with builder’s risk coverage and may require proof of this during approval.
The underwriting process can take time because all the details must be verified. During underwriting, you must provide any additional information requested by the lender to verify your qualifications for purchasing the home.
Additional Fees to Expect During Custom Home Building
You will likely anticipate many of the costs associated with building a home, including contractor fees, material costs, and the purchase price for the lot.
However, there are other costs you also need to be aware of, including:
- Closing Costs: These typically amount to 5 to 7% of the home sale cost and cover administrative fees, application fees, and other costs related to obtaining the loan. They are not included in your down payment. Loan origination and lender fees are included, as are costs associated with loan processing, document handling fees, title change costs, and other potential fees for credit inquiries.
- Builder Deposit & Earnest Money: The builder may require you to provide some earnest money (security deposit) upfront, showing good intentions.
- Property Taxes: During closing, you will pay for a year’s property taxes.
- Inspection & Appraisal Costs: You may need to pay these costs ahead of the closing for the loan, and they can range widely.
- Flood Certificate: This is only required if your home is in a flood zone.
- HOA Fees: These costs should only be considered if your home is being built in a community under a homeowner association. During closing, you may have to pay at least one month of HOA fees, which can range from $120 to $350. Some HOAs may require you to prepay several months’ worth of dues.
- Insurance: You will need to have homeowners insurance in place before closing.
Have Questions? Contact Cherry Creek Building
Cherry Creek Building has been designing and constructing custom homes in Michigan for over 30 years. We understand the challenges and obstacles that can occur during a custom-build project and are here to help guide you through them.
If you’re just starting this adventure, please contact us today for a consultation—we can help you understand the process better, recommend lenders, and review some of our home design options.