Building a custom home is an incredibly exciting process. Unfortunately, paying for the construction isn’t quite as satisfying. We try to make the process as smooth as possible, and we’ll do our best to lay it out for you so that it’s as painless as possible when the time comes. Working out a construction loan is an intricate process, but when it comes down to the basics, it’s actually quite straightforward. We’ll break it down in an understandable way, and provide some further detail in this article, but if you ever have any questions, the Loan Officers at our lenders can walk you through the process whenever you’re interested in taking that step, so don’t be afraid to give them a call.
When considering building a new house, if you’re like most of us, you’ll want to obtain a loan to help pay for the costs. While you’re likely familiar with a mortgage, the loan that you would obtain from a bank in order to purchase an already built home, you might not be familiar with a construction loan and how that differs.
What Does a Mortgage Cover?
Let’s start with a mortgage, which can also be referred to as a permanent loan. A mortgage is the loan that you’d receive from a bank or mortgage lender to cover the cost of purchasing an existing house. These lenders are willing to lend you the large sum needed to cover the cost of purchasing a home in exchange for paying them back over a specified period of time (typically 15 or 30 years) with monthly payments that also include an interest rate. Over the specified period of time, you’ll eventually pay the lender back in full, plus the agreed upon interest rate, which is essentially the cost of obtaining a loan. The reason that a bank or other lender is willing and able to provide such large sums of money is because the house that you purchase is considered collateral. If, for whatever reason, you can’t pay the lender back, they can take ownership of your home and sell it to a new owner in order to recuperate their investment.
What does a Construction Loan Cover?
Construction loans are quite different from permanent loans as they apply to new construction rather than to the purchase of something that is already built. When looking at the loan from the lender’s point of view, the reason for the difference between the two is the lack of collateral. If a bank were to lend an individual several hundred thousand dollars to build a home, and that home never ended up being built, they wouldn’t have any way of recovering their investment if the individual neglected to pay them back. Hence, a difference in loan structure and the need to work with an outstanding builder with a history of good work.
When constructing a new home, you’ll typically need both a construction loan and then a permanent loan. The construction loan covers the building process while the permanent loan pays off the construction loan covering the actual overall cost of the home and land (if you roll land into the loan). Luckily these loans are typically combined to make for an easy process. Schumacher Homes’ lenders are able to issue these loans in such a manner to keep the financial factors of building your new home relatively easy.
The primary difference between the way that a construction loan and a permanent loan works is in the way that a construction loan is paid. While a mortgage would distribute the full amount right up front, asking to be repaid over a number of years, a construction loan is a short term loan - typically just one year - that will pay the builder in planned installments (referred to as draws) after key construction stages are completed. You, as the borrower, will pay only the interest on the loan over the course of the year following the draws and the balance will be converted into a permanent loan once construction is complete, just as if you had purchased an existing home, allowing you to pay the loan back over a long period of time. At that time you’ll have regular principal and interest payments. Our preferred lenders offer one closing for both loans with no change in rate for qualifying applicants.
We know, it’s a little confusing. So let’s dive into this a bit more...
Construction loans are typically very short in length. Unlike a mortgage, these loans are usually just nine months in length and are written on an agreed construction schedule. One major benefit to working with a long established custom home builder, such as Schumacher Homes, is that we have a storied history in both construction and in working with lenders to secure loans for our clients. This combination of experience makes it relatively simple to work the timing and financials out with the lender. It’s important both for the banker and for you to know that the construction process will be laid out in a proper manner and then executed as such.
Essentially, you and your loan officer are on the same team and the lender will help evaluate your builder’s work to be sure that everything that they lay out as far as costs and timelines make sense. If you’re working with a lender who has experience with construction loans, they’ll know what to look for and will help you be sure that everything is on the up and up. That’s one of several important reasons that working with a lender who specializes in construction financing and understands the process is so important. It’s the bank’s money that is on the line, so they’re on your side, but many banks don’t offer construction loans or don’t do them adequately which can cause delays in securing the mortgage and paying the builder during construction.
Construction loans are short, usually just nine months and are dependent on the appraisal (see below), which again, is why it’s important to work with an experienced and trustworthy builder. Banks consider a construction loan higher risk because there is no collateral to start and are much more willing to work with established builders. The only collateral that a bank has on this loan is a finished house, so it is in their best interest to favor builders who they trust to finish the job on budget, on time, and with utmost quality.
Construction loans may require a 20% down payment on whatever the appraisal amounts to. Our lenders may have programs that include down payments as low as 3.5%-5% for the whole project including the house and land for qualified applicants. Outside of that down payment, you may not need to pay any of the principal until construction is complete with those programs. Rather, over the course of construction, you will only pay the interest on the loan rather than any money that goes towards the principal. Once construction is completed, the remainder of the principal will be transitioned into your permanent mortgage and be paid over whatever length of time is agreed upon between you and your lender (typically 15 or 30 years).
Just like when an appraiser walks through an existing home to estimate the value before agreeing on a mortgage, a construction appraisal must be done in order to settle on the value of a construction loan. The only real difference between these two sorts of appraisals is that a construction appraisal is judging plans rather than an existing product. Just like with an existing home, the appraisal will look at the location of the future home along with the proposed size of the home, permanent amenities in the home, and any recent home sales in the neighborhood.
As mentioned above, the builder is paid according to a structure set ahead of time through disbursements called draws. Essentially, this is just how you might pay a builder if the money was coming straight from your bank account. The builder will be paid out upon completion of different major elements of the process such as framing, plumbing, etc. Meanwhile, you continue to just pay the interest owed.
Once the house is 100% complete, the builder will have been paid all that they were promised for their work. This is when your loan converts to a permanent loan, and you begin paying the bank back on the money that they have dispersed to the builder throughout construction. Essentially, you’re starting a new loan so that you can pay back the construction loan.
This likely goes without saying. Nobody wants to work with a bad builder! But you may not have realized that the custom home builder that you choose can dramatically affect your construction loan. Banks will also take the builder into account when evaluating your construction loan. Poor underwriting decisions can be costly to banks when construction goes wrong, stops midway, or winds up costing more than initially quoted for a variety of reasons. When this happens, the bank may lose money. This is why they prefer working with established companies like Schumacher Homes who have a long history in the industry and have established a great deal of trust with major financial establishments. While you want a stunning, well built home, banks just want to mitigate their risk - Schumacher Homes provides each side with just what they need.
If you’re looking to build a custom home, you’ll need to obtain both a construction loan and a permanent loan (mortgage). The construction loan is a short term loan that finances the construction process by paying draws to the builder as designated milestones are completed. Meanwhile, you will only pay a down payment along with the interest payments. The construction loan then converts into a more standard permanent mortgage loan once construction is finished, at which point you’ll begin paying back the lender on the total for the entire home (principal + interest). To learn more about the process of obtaining a construction loan, visit this post.
Schumacher Mortgage LLC (NMLS #2101256) is Schumacher Homes’ affiliate which specializes in construction loans. Together, we want to make your dream home building a smoother experience from start to finish.
We have worked with Schumacher Homes on countless projects. Schumacher Mortgage Loan Officers are experts in construction loans, offer top level customer service, and offer you great loan terms and options. Very few banks and lenders are as experienced in construction loans. When you work with a traditional bank or lender that does not specialize in construction financing, you may have limited program options available to you and may experience delays, both in getting your final mortgage as well as in the construction of your new home.
But with Schumacher Mortgage, you should expect a smooth process from start to finish. Our team is comprised of people who have many years of experience working with Schumacher Homes. When you choose to work with Schumacher Mortgage as a Schumacher Homes customer, it means a streamlined construction draw process, meaning fewer building delays and a faster build for you!
Not only can we provide a collaborative, enjoyable experience when partnering with both Schumacher Homes and Schumacher Mortgage, you can expect competitive interest rates.
Schumacher Mortgage and Schumacher Homes are two separate companies. Schumacher Homes helped form, and has a major ownership position in Schumacher Mortgage, because it wanted to ensure that its customers would have both a wide range of flexible construction loan programs and superior customer service. Customers may seek home financing from the mortgage lender of their choice, but when working with both the Schumacher Homes and Schumacher Mortgage teams, we think customers obtain a more streamlined home loan process.
Schumacher Homes, based in Canton, Ohio, is America’s largest custom homebuilder, with operations in 30 markets in 12 states across the country. The National Housing Quality award winning company has built over 20,000 homes, customized to fit each family’s lifestyle, since its founding by Paul Schumacher in 1992. Schumacher Homes takes each customer’s inspiration and gives it a home. Each Schumacher Homes location includes a one-stop shopping design studio and model homes displaying the latest in architectural and product trends. Stop in today, be inspired and receive your no obligation price quote.