Financing a custom home build is not like financing the purchase of a home that is already built. With a traditional home purchase, you’ll be looking to secure traditional financing through a mortgage, but when financing a custom home build, you’ll need to secure financing for other stages of your home building journey.
This means securing financing when purchasing your lot. It also means finding financing for the construction stage of the custom home building process and then converting that loan to a permanent loan once your home is built. As a custom home builder in Boise, we have first-hand experience with the custom home financing process. We’ll share this experience here to help you understand the fundamentals of custom home financing, both the types of financing you’ll need when building a new home and the general process to secure financing to build your dream home on your land.
3 Types of Financing For A Custom Home Build
Land Loans / Lot Loans
When building a custom home on your land, you’ll first need to buy land to build on. For this purchase, you’ll need a land loan, also sometimes referred to as a lot loan. If you are using cash for your land purchase, you’ll skip this piece of financing and go right to the construction loan when you start your build
If you aren’t using cash to finance, then you’ll need to secure a land loan as the first piece of financing for a custom home build. Here is what you need to know about land loans.
Note: There is no industry standard to differentiate a land loan from a lot loan. Some financial institutions use the terms interchangeably, while at others there are differences between a land loan or lot loan. In this article, we will use the two terms interchangeably.
For most land loans, there is typically a larger down payment required than that of a traditional mortgage loan because with a land loan the loan-to-value ratios allowed are often lower than those of traditional mortgages. We’ve seen loan-to-value maximums from 70-80% for Idaho land loans, meaning your required down payment would be between 20-30% to secure the loan.
Note: Loan-to-value ratios will be used throughout the process of securing financing for your custom home. See Investopedia for more information on loan-to-value (LTV) ratios, how to calculate them, and how they may factor into your financing options.
Another item to note is that land loans may come with higher interest rates and shorter borrowing terms. For many lenders, a land loan is considered the first step in your custom home financing and may therefore only be available as a short term loan, such as a two years. In this case, the lender would expect you to begin building on the land within or at the end of this two year period, when you would then update your financing to a construction loan.
If you aren’t planning to build a home in the short term, but are buying land for future home construction, other land loans with longer terms exist, maybe up to 20 years, but it isn’t as common to see a land loan term of 30 years as it is with a traditional mortgage. Some lenders may offer varying land loan terms, so check with your lender to understand the options available to you for a land loan.
If you are looking for a lender in Boise area, you can check in with Sabrina Polfer to learn more about your financing options and get pre-approved.*
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Regarding interest rates, land loans also typically have a higher interest rate than a traditional mortgage because a land loan is seen as a higher risk loan. Lenders may see a land loan as a higher default risk because in the event of harder financial times a land loan may be less likely to be paid than a home loan. As with any loan, interest rates for land loans will also be dependent on your financial situation.
If you are purchasing a large plot of land, you may also want to check with your local lender about any size or value limitations they have for lot loans as lenders may limit the amount, both monetary value and acreage, they are willing to finance for a land loan no matter what your financial situation may be.
To get an idea of lot loan payments, you can use a lot loan calculator such as WaFd Bank’s Idaho Lot Loan Calculator.
Summary of Land Loans:
- Higher down payment is often required
- Higher interest rates than a traditional mortgage
- Short term and long term options available
- May be limitations on acreage that can be financed
- May be limitations on maximum loan amount, regardless of financial status of borrower
What if you already own the land?
If you already own land the first step in financing a custom home build will be your construction loan, which you’ll want pre-approval on before you start designing your custom home build as it will impact your home building budget.
Want more information on the building process? Learn more about the steps to get started on building a custom home on your land.
Construction Loans
Construction loans are probably the most confusing for anyone who has never gone through the process of financing a custom home build. For this reason, we also created a comprehensive guide to construction loans. Here, we will focus more specifically on how construction loans fit into the financing of a new home build.
After you’ve purchased land to build your home on, you’re next step in financing your custom build is to secure a construction loan. There are several types of construction loans, but the standard construction loan is one that covers only the construction phase of your project. With this type of loan, the loan amount is paid out over time as the construction of your home progresses. From a payment perspective, you will be paying just the interest on the loan until construction is complete and the full loan amount is paid.
Construction loans for custom home builds are short term loans, usually one year or two years, depending on your custom home build schedule. Once your home is built, your construction loan ends and you’d secure a permanent loan or mortgage as the final stage of financing a custom home build.
A common type of construction loan, known as construction to permanent (C2P) loan or a one-time close loan, allows for a single loan process that allows your construction loan to automatically convert to a permanent loan once your home construction is complete. This means you don’t need to pay for multiple appraisals or closing costs and it’s a lot less paperwork for you.
One consideration for a construction loan is that the construction loan interest rate is often higher than a permanent loan or mortgage interest rate. This is because the bank is lending against an asset that isn’t complete. Versus a loan on an existing asset, there is more risk for the lender in a construction loan in case something goes wrong or construction is not completed for some reason.
When you use a construction to permanent loan, you’ll be locked into an interest rate based on today’s rates during and after construction. When you secure a separate construction loan, your permanent loan rates may change based on the interest rates at the time your home construction is completed. Both options have their pros and cons.
Can you get a construction loan if your land is not yet paid off?
Yes, you can get a construction loan even if you are still paying for your land with a lot loan. Typically, the amount you have already paid toward your land can be used as the down payment for your construction loan. Your construction loan lender is likely to include the remaining balance on the land in your loan and will pay off the remaining land loan as part of your construction loan. This benefits you in not having two separate loan payments to make. At the same time your construction loan lender benefits by moving into the “first lien position”, meaning they’d be first to be paid versus the original land loan lender.
How Your Custom Home Builder Is Involved In Financing A Custom Home Build
To secure a construction loan, you’ll need to submit your custom home build plans as part of the loan process. The construction loan lender will be using these plans to determine the appraised value of your custom home and the amount and schedule of your construction loan.
Your custom home builder is typically putting the build plans together for your lender to review. In addition, your lender may also want to approve your builder based on the submitted plans and their past project history because your loan is so dependent on the builder following through with the plans within the budget. The risk to the lender comes from both you and your builder, so the home builder you choose can definitely impact the custom home financing process.
The schedule of your construction loan is also impacted by your custom home builder. For construction loans, the payout schedule is often based on a percentage of completion or stages of construction being completed. For these payments, your home builder often submits a draw request and your lender will verify that the work has been done before releasing the funds for that stage. The home builder you work with can certainly make this process easier or more difficult depending on the organization and management of your project.
See these tips on how to choose a custom home builder to help you find a builder for your new home.
Summary of Construction Loans:
- Land value and any payments made for land can be used toward your construction loan down payment
- 20% down payment minimum is typically required
- Higher interest rates than a traditional mortgage
- Short loan term loans – 1-2 years is average based on your home build schedule
- Loan paid out in segments as construction progresses versus lump sum payment
- Appraisal and loan amount based on custom home build plans
For more information on construction loans, check out our comprehensive guide to construction loans.
Traditional Mortgage / Permanent Loan
If you’ve opted for a construction to permanent loan, then this last phase of financing a custom home build will automatically be taken care of once your home construction is complete. Your construction loan will be converted to a permanent loan which is very similar to a conventional mortgage. Your payments will change to a set monthly payment of interest and loan principal and the loan term will be updated based on your original loan schedule.
If you haven’t opted for a construction to permanent loan, at this point in the financing process you’ll be going through another loan approval for your permanent loan. Permanent loans function much like traditional mortgages. They have a set interest rate, typically very similar to rates for a mortgage because there is less risk for the lender now that you are borrowing against a fully constructed asset. The payment schedule for your permanent loan is a set rate of interest and principal just like a mortgage and you’ll need to have a similar financial background and credit score to secure a permanent loan as you would need for a regular mortgage.
Once your construction loan principal is due your permanent loan will pay off the principal in one lump sum, just as a mortgage will pay for a fully constructed home in one lump sum when you buy a new home.
Summary of Permanent Loans:
- Interest rates similar to a conventional mortgage
- Loan terms similar to conventional mortgages
- Paid out in one lump sum for the balance of the construction loan
- Need to go through a second appraisal & loan approval upon home completion, unless using a construction to permanent loan
How To Get A Loan For Financing A Custom Home
The process to go about financing your custom home is in some ways similar to a standard home purchase. You’ll need to find a lender and provide details of your financial status to prove you can afford to build a custom home. When looking for a lender for custom home financing, you’ll need to find one that offers the loan types you need, which may include one or more of the loans we’ve covered here. During the process of reviewing finances, you’ll need to be able to show you can pay for a larger down payment for land or construction loans and afford the higher interest rates on these loan types.
The biggest difference in the process of securing financing for a custom home build versus a standard home build is that you’ll need to submit detailed plans of the home you plan to build during the construction loan approval process. For this reason, your construction loans don’t cover any design costs because this step in the custom home building process comes before you secure your loan. The design impacts how much it costs to build a custom home and therefore how much you’ll need your loan amount for. Working with a reputable custom home builder who understands this part of the financing process can have a large impact on actually getting approved for your financing and in some cases the interest rates of your loans.
Conclusion
If you are considering building a custom home in the Boise area, you can use our instant quote tool found on all of our custom home plans to give you a better idea of the cost to build. You may also be interested in exploring more on building versus buying a home in Idaho or our other home building resources.
At Pathway Builders our experienced team of home building professionals is here to help with any of your home building needs. Please feel free to contact us with any questions or to set up a time to talk about building a home on your land in Treasure Valley.