This might be the most exciting day of your life because I am holding a TON of piggy banks about to talk about LOANS! But seriously, I am VERY excited to discuss this topic with you because there are lots of misconceptions about how anyone can afford to build a house. The answer is...most people do it with loans! I was completely overwhelmed by this process when I started, but I have since learned SO much and want to share that with you...
Here's what most people think about paying for a huge home project (a custom build or major renovation):
A. You need all cash to build a house. (NOT TRUE. I don't have cash just lying around, and here I am doing this crazy project!)
B. You need to have saved up a lot of money. (SORT OF TRUE. You do need to have some savings to be able to qualify and provide a down payment to close a loan. The amount of the down payment will vary, but could be up to 20-25% of your loan amount. However, things like owned land can be used as equity towards this down payment.)
C. You can use a credit card to pay for a home renovation. (NOT A GOOD IDEA. Credit card interest rates are much higher than a loan and unless you are using a credit card to help your overall credit, get points on your credit card, and then pay off each month in full, then don't do it.)
Mortgages vs. Construction Loans
You may already be familiar with mortgages if you've ever bought a home or are in the market for a home. A mortgage is a loan you can get to buy an existing house that you pay back over time (10, 15, 30 years, etc.). The amount of the mortgage you are given is based on your financial credit, cash flow, income, and the value of the home you want to buy. Construction loans are similar but also different. If you do Google search for "Construction Loans", you will get a ton of information about it. All of that information can be overwhelming and confusing, so I wanted to explain how they work from my experience over the last couple years.
Essentially, Construction Loans can be used to build a house from scratch or to do major renovations on an existing house.
Here's how a Construction Loan works:
1. In order to qualify for a Construction Loan, you need to first be approved for a Mortgage. The Construction Loan that you could get will eventually turn into a Mortgage when your renovation work or your new home is finished. So if you don't already have a mortgage, a bank needs to work backwards and first approve you for the Mortgage that you will eventually be paying off over time. This process is the same as applying for a Mortage, except that even if you are approved for the mortgage, it's not guaranteed you will be approved for a construction loan. You still need to go through additional steps to qualify.
2. A bank will usually lend you 70-80% of the value of your finished home. So, hypothetically (with made-up numbers here), if your finished home will be valued at $100,000, the bank can approve you for $70-80K in a construction loan. In some cases, that amount could completely cover the cost to build or renovate your home. But, let's say your work will cost $85K and the bank can only lend you $80K, you will need to come up with the difference of $5K to get approved for the Construction Loan (in additional to standard financial paperwork). Now, if you already own a home with a mortgage and looking for a Construction Loan for major renovations, your current mortgage will get factored into how much a bank can lend you for construction.
3. In a Construction Loan, the bank pays the contractor — not you. So, let's say you do in fact get this hypothetical $80K from the bank to cover the cost of your construction. Once the work starts, your contractor would request draws from the bank regularly (usually monthly) by providing a record of what work was done and what funds are being requested to be paid for. The contractor sends a "draw request" to you, you sign off on it, and then the bank pays that amount to the contractor. Sometimes the bank will send someone out to your project to make sure that work has, in fact, been completed before paying that amount. This process happens monthly until the project is completed. This is when a qualified and organized contractor comes into play because their ability to stay on schedule and complete the work that they are asking to be paid for will be reviewed by the bank regularly in order to get each phase of the project paid for.
4. Once building is complete, home construction loans are either converted to permanent mortgages or paid in full. Depending on your type of construction loan, you have either decided you will pay off the cost of your construction by the time the project is done. Otherwise, the money that you borrowed from the bank to pay the contractors now turns into a mortgage which you will pay off over time just like any other mortgage.
Now, keep in mind, I am not a bank nor am I a finance person. This explantation is a "101 of Construction Loans" and how I would explain it to a friend or family member asking me about it. But, if you have any other questions...please feel free to ask in the comments below and I will do my best to answer!
You can see more over at my post on Architectural Digest's Clever to see the details on what a Construction Loan can cover.