Big Dreams, High Dollars: Financing Your Dream Home

We have all browsed through home magazines featuring luxurious dwellings, and many of us dream of someday building our own or renovating what we have. But it takes funding—usually lots of it—to make this dream a reality. Financing a home, whether a new custom home or a large-scale renovation, is a process that requires thought, preparation and good contacts with financial institutions.
Securing funding can be stressful, especially if you dive in without a good understanding of the process. Since the avenues necessary to borrow money are almost as diverse as how the money is spent, it is crucial to understand your lending options. Know how much you expect to borrow and how you can pay it back. Then go to your local bank, credit union or specialty financial service company to learn about the types of financing they have to offer for your particular project.

Financing a Custom-Built Home
Prospective homeowners can choose from a selection of home models that their contractor will build, or they may design a custom home that meets all of their needs and desires. If opting for a custom home, it is important to understand the financing process. Finding an institution that will provide the necessary loans takes time. Securing funds for a custom-built home is more involved than funding a tract home. Expect to spend several months in negotiations with lending institutions before finding the right arrangement for your particular project.
Typically, a custom home is initially financed with a residential construction loan. Once the home is completed, it is followed with permanent financing in the form of a mortgage.
Look for lenders who specialize in construction financing. This may take longer than it would to find financing for an existing home because of the specialized nature of this loan. Your general contractor can often provide resources for financing the actual construction portion of the project.
The custom home is used as collateral for the construction loan, assuming the homeowner has been approved based on credit scores and personal financial data. According to Debbie Carpenter of HomeTown Mortgage, when the borrower has ample equity in a different property, the loaning institution could use a variety of portfolio or secondary mortgage market products to fund the construction.
Jamie Asciolla, at Freedom First Credit Union, explains that with a construction loan, “Rather than issuing the entire loan funds at once, the funds are held in escrow and dispersed at regular intervals upon satisfactory completion of specific work.”
Construction lenders rarely provide all the funds from a construction loan immediately. Instead, they pay out the loan in multiple periods as each portion of the construction project is completed. The first installment may pay for the purchase of the land, if it is not already owned. The loan should outline the number of draw periods and the requirements for each. The next draw is contingent upon the successful inspection of the work or other documentable benchmark. The borrower will pay interest only on the amount the contractor draws as the house is being built.
When seeking a loan, a homeowner should plan to offer a down payment of at least 20 percent, which helps avoid additional monthly PMI costs. (PMI, or private mortgage insurance, is extra insurance that lenders require from most homeowners who obtain loans that are more than 80 percent of their new home’s appraised value.)
Carol Potts of PrimeLending expects prospective borrowers to bring in copies of their tax returns for the past two years, W-2 forms for the past two years, pay stubs for the past 30 days and asset statements for the most recent two months. This type of information is standard and is universally requested by lending institutions.
Today borrowers must be prepared to answer many questions and expect credit checks. Long-range planning is helpful if you think that someday you will be looking for home financing. A few things to consider include the following: Pay bills on time, avoid opening and closing numerous credit and bank accounts, keep your credit card balance below 50 percent of your credit limit, and document all deposits placed into your asset account. Avoid co-signing a loan for a family member or friend. Keep your income and asset information organized.
A great deal of documentation is required for construction loan approval—far more than is required for a standard mortgage. Remember, the home does not exist yet! The lender must review plans and budgets which hypothetically value the home based upon assumptions provided by the house plans. The lender also must be sure that the borrower will qualify for permanent financing once the construction phase is completed.
Experts recommend that homeowners then apply for the previously-approved permanent financing between 30 and 60 days prior to completion of the home. Some lenders permit the homeowners to refinance the construction loan, instead of treating it as a purchase mortgage. Refinance mortgages do not usually require a down payment; purchase mortgages do. This allows the homeowners to use the equity built in the home, rather than requiring an additional five percent or more down payment that is typical in a purchase mortgage.
Research your lending options before choosing a construction loan company. It’s important to note that national banks do not offer construction loans, so homeowners must choose among local community and regional banks for these funds. Homeowners may want to look to their contractors for guidance when selecting a bank. Contractors are familiar with the local banks and usually have developed good working relationships with individual institutions. These relationships are built on mutual respect and these contacts will often yield favorable results when homeowners are seeking funding.

Financing a Home Renovation
Perhaps building a new home is not in your plans. You love your current home and its location, but a few changes would make it perfect. A renovation might be just the answer.
It is important to consider the size of your project and how much you need to borrow before choosing a type of financing for a renovation. Whether it is building an addition or giving a room a facelift, renovations usually increase the resale value of your home. Consider the amount of money necessary for the project. How much is needed up front? Or is the money needed in stages as portions of the project are completed?
The first step is to get preapproved by a lender. Then talk to your contractor and make sure that the budget is at least 10 percent less than the lending institution has approved. According to Carol Potts, most renovation projects will build in this contingency reserve to cover any unforeseen costs.
Financing a renovation is affected by a borrower’s equity position before and after the project. For a large renovation, the loan is treated like a construction loan. For a smaller project, a fixed-rate home equity loan or home equity line of credit (HELOC) would be a good choice.
A home equity loan works somewhat like a conventional first mortgage. A lump sum is borrowed and payments are amortized over several years. Usually the interest rate and monthly payments remain fixed throughout the term of the loan. This option requires an additional payment on top of your first mortgage and usually carries a higher interest rate than refinancing your mortgage. Closing costs may be lower, and if you need the money all at once, this may be the loan option that is best.
A HELOC is a good choice if you will be paying for your project in stages. Richard Socha-Mower of Member One Federal Credit Union explains that unlike a fixed-rate equity loan where the loan amount is funded all at one time, a HELOC allows the borrower to obtain an approved “limit,” making home renovations easier since you can borrow as needed and pay only interest on the advances taken. The lender agrees to advance money up to a specified limit, and you access the money as needed with a credit card or checkbook. The lender establishes a credit line which is similar to the borrowing limits on your credit card. You can write checks for any amount up to that limit as you need it.
Socha-Mower explains that a second mortgage is a separate loan from your original first mortgage, tied to the property in second lien position. A borrower will use “equity” in his or her property to obtain a loan secured by the primary residence. Equity is the difference between what a borrower owes on a property and what the value of that property is worth. A second mortgage can be paid back in fixed-rate programs such as a 5-, 10- or 15-year amortization. The interest on this loan may be deducted from your taxes, but be sure to consult your tax advisor in this scenario.
Refinancing the mortgage is another option if you have already built some equity in your home and you are planning a major renovation. Depending upon the term, the monthly mortgage payment might remain the same, only the length of the loan may be extended. If the renovation is something structural, lenders may approve the loan based on the projected value of your home after the project is completed. A personal line of credit works for a small project. The fees to set these up can be lower, and since they are not secured with your home, they carry a higher interest rate and are not tax deductible.
The federal government offers renovation loans, but the application process can be complicated—time-consuming and difficult to complete. For more information on what the federal government has to offer, check out their website at www.hud.gov.
Homeowners have many options when it comes to financing home improvement projects—or even that custom-built dream home. But you have to do your homework. If it’s a big renovation or new construction, talk to several builders and make sure that the company you choose is qualified to do the work. Your local home builders’ association can provide names of qualified builders in your area. Work with a loan officer who has experience. Have all of your documentation organized. Decide what size loan you qualify for before finalizing any construction or renovation plans. With these preparations, you’ll already be well on your way to having the home of your dreams.
Special thanks to the following people at these lending institutions who provided their expertise for this article:
Melissa Mason, Debbie Carpenter and Joanne Polly at HomeTown Mortgage
Carol Potts at PrimeLending
Jamie Asciolla at Freedom First Credit Union
Richard Socha-Mower at Member One Federal Credit Union