You’ve decided to build a new home and you’ve done your homework by finding your ideal lot, finding a home builder, and signing a contract. Now, how will you pay for your new home? When will you have to put down cash? In my last post we discussed contracts, so let’s try to address some of these questions by reviewing cash flow and financing as it relates to the construction of your new home. Keep in mind, these same points apply to remodeling projects. Please contact me if you have additional questions or wish to discuss this process a bit further.
Obtaining Financing
Once a contract is signed, the next step is obtaining financing for your new home. Based on your financial situation, a bank will typically lend approximately 75% of either the appraised value of the home or the actual cost – whichever is less. If a lot is being purchased first, this “rule” also applies. An example will help clarify this:
Lot = $50,000
Home = $300,000
________________
Total cost $350,000
Bank willing to lend = $262,500 (75% of $350,000)
(assuming appraisal of > $350,000 total)
Customer Equity/Balance: $350,000 – $262,500 = $87,500
The bank will determine, based on your financial situation and relationship with them, WHEN your equity ($87,500) will be due. This can vary from immediately, to late in the construction process. This timeline is important to understand and plan for as you consider financing for your new home.
What is a Construction Loan?
Construction starts with a “Construction loan”. This is a temporary loan so that construction can take place. The loan typically expires in one year, or when the home is complete – whichever comes first. Once the construction loan is in place, the home builder makes “draws” on the loan (usually monthly) based on the work completed. The bank will inspect the job to ensure the work on the draw request is complete. The bank may also do a title search to ensure bills are being paid properly. If the contract is a Cost Plus Contract the buyer will see the invoices and review them with the builder for approval prior to submitting to the bank. In a Fixed-Price Contract the client typically does not see or review the draw request.
Managing Project Budget and Change Orders
As the home is built, actual costs can vary from the proposed budget. Additionally, buyers usually want to make some changes along the way. How “change orders” and budget discrepancies are handled varies highly by the type of contract and by the home builder. This is a very important part of the client/home builder relationship to understand. It ultimately comes down to trust. It is a good policy to settle all change orders as they occur to avoid misunderstandings.
Example: If the buyer decides to change the kitchen counter-top from laminate to granite during a typical progress meeting, the home builder should prepare an estimate of the cost of the change, have the buyer review and approve it before the granite is ordered. This will insure the buyer really wanted the change and understands the additional cost. When this change order is paid is dependent upon what the home builder and buyer have agreed to in the contract. In my opinion, it is a good policy to have change orders paid at the time they are executed so the buyer is fully aware of the additional costs to the project. It is not advisable to “settle up” change orders at closing as this normally leads to disappointment and sometimes disagreement as to the amounts owed. In my experience, closings should be a fun event, so I recommend keeping the formal parts current during construction.
What to Expect at Closing
Once construction is completed there is a “closing”. At this time a permanent loan is put into place replacing the “construction” loan. You will have applied for the permanent loan during construction of the home. The loan term of 10, 15, or 30 years is your option, based on your ability to pay and how long you want to take to pay it off. The balance of the equity is normally paid to the builder at this time. Be sure to plan a meeting with your financial advisor to discuss these options, as this will be different for each buyer based on their immediate and long-term financial goals.
Hopefully I was able to hit on some key points that will help address your questions around cash flow and financing of a home building project. If you still have questions, please feel free to contact me and I’ll be happy to discuss this with you further.