Need a Loan to Build a Home? Here’s What You Need to Know.

     There's something deeply satisfying about watching your home get built from the ground up. If this is the route you want to take, it’s important to understand how construction financing works and the steps you should take for the process to go smoothly.

Start With a Budget

     Some people are big-picture people, while others are better at details. A construction project can benefit from both. Once you’ve got the grand plan, you need to put a price tag on all the specifics. This allows you to figure out what you can afford and helps you know when things are going off track.

     Every construction project suffers from some level of “creep,” the term used to describe the little upgrades that can blow your budget to smithereens over time. Contractors often mention options as your project progresses. For a little extra, you could make the bathroom a bit wider or upgrade those fixtures. Each individual decision seems reasonable, but taken together, the upgrades can put you thousands of dollars over budget.

How Construction Loans Actually Work

     One thing that surprises first-time builders is that the bank doesn't hand you a check for the full amount of the loan on day one. Construction loans are distributed via staged payments, called draws, released as specific phases of work are completed.

     Based on input from you, your builder, and your architect, your lender will establish a draw schedule based on a master list of tasks, from site grading all the way to the final occupancy permit. On a $200,000 loan, there may be five draws of $36,000 each. When all the tasks for a certain phase are done, the lender releases that draw. Then the process repeats until the house is finished.

     If you’re doing the math, you’ll notice that multiplying $36,000 by 5 only gets you $180,000. That’s because lenders typically hold back around 10% of the total loan as a reserve, which isn't released until the project is fully complete and the occupancy permit is issued. This protects the lender (and you) by creating a financial cushion for the inevitable surprises, and it keeps everyone honest about finishing the job properly.

Converting the Construction Loan to a Home Loan

     When you get a construction loan, the traditional path is a two-step process: you take a construction loan, complete the build, then go back to the market for a conventional 30-year home loan, called a "takeout" loan.

     The alternative is to bundle the construction loan and the permanent financing from the start, called a one-step close. When construction wraps up, your loan simply converts to your home loan with minimal paperwork and no second round of closing costs. The tradeoff is that you lock in your interest rate at today's terms. It's a calculated risk, but for many buyers it’s worth it. If rates drop significantly after you close, you can always refinance.

Protecting Yourself With the Right Contractor

     Choosing the right builder can mean the difference between a relatively smooth process that ends with you moving into the home you’ve always wanted versus fighting off angry subcontractors who blame you for getting cheated by the general contractor.

     So, don’t go in blind. Ask your contractor for references—and actually call them. Better yet, see if you can find people who used the contractor but weren't on his reference list. Ask your neighbors. Check with people in the trades. Do some digging. This is a small town; you can usually sniff out bad apples.

     If you don’t, you could be left with mechanics liens. If your contractor fails to pay the plumber, the electrician, the framer, or any other subcontractor, those workers have the legal right to place a lien on your property, even if you already paid the general contractor for that work. This happens more often than you’d think. Protect yourself by requiring proof of payment to subs as the project progresses.

     Once you have a contractor in mind, verify everything. Call their insurance company to confirm their liability coverage and workers’ compensation coverage are current and paid up. Call the State of California to confirm their contractor's license is in good standing. Building a home can allow you to create the space you’ve always dreamed of. Just be sure to do your due diligence up front and stay engaged throughout the process.

     If you have questions about property management or real estate, please contact me at [email protected] or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.

     Dick Selzer is a real estate broker who has been in the business for more than 50 years. The opinions expressed here are his and do not necessarily represent his affiliated organizations.