Build the home of your dreams with the help of these financial opportunities.
It’s always been your dream not to simply buy a home where you can one day retire, but to build one from the ground up that is perfectly suited to your vision for how you want to spend your years. To achieve this dream, two of the major financial options to consider are borrowing against the value of your current home with a home equity line of credit or taking out a construction loan.
What Is a Construction Loan?
Steve McLinden, a real estate advisor for Bankrate, explains a construction loan is typically a short-term loan that carries a higher interest rate than a conventional mortgage. They’re colloquially called story loans because the money is lent without the collateral of a finished home; instead, you present your lender with a detailed budget and timetable to receive the loan. McLinden notes the lack of collateral also makes these loans more difficult to obtain without a well-maintained credit history.
According to Beth Buczynski of NerdWallet, lenders will scrutinize your:
- Credit score
- Debt-to-income ratio
- Plans for repayment
Different Types of Construction Loans
Buczynski notes two major categories of construction loans for building a home from scratch: construction-to-permanent and construction-only. A construction-to-permanent loan becomes a mortgage at the completion of construction and locks in your interest rate at the time of closing. Construction-only loans specifically cover the construction phase, which makes it ideal if you want to obtain a mortgage elsewhere or plan to use the profits from your previous home and other cash reserves; but it also requires you to pay closing costs multiple times.
If you are approved for a construction loan, the money is meted out in draws, which follow your provided timetable to accommodate stages for construction from start to completion. Dr. Don Taylor, also of Bankrate, notes that this approach makes it imperative for your project to stay on schedule — interest accrues over the period of construction, and the longer you take to get the job done means more money spent.
Why Consider a Home Equity Line of Credit?
If you’ve lived in your current home for some time and therefore have established sufficient equity, a home equity line of credit is an option for financing the construction of your new home. Natalie Campisi of Bankrate notes that HELOCs are easy to open — so long as you have equity — and only charge interest on the amounts you borrow.
Campisi also points out that these loans tend to come with variable interest rates, may require an annual fee and can become problematic if the value of your home decreases. If you plan to sell your current home and move into your newly constructed home, however, then you’ll have less to worry about with the major drawbacks of HELOCs.
Writing for The Balance, Sensible Money LLC CEO Dana Anspach puts forth the idea of using a HELOC to pay for the down payment on a new home, and the same logic applies to fund construction on fertile ground. Anspach suggests this is a preferable alternative to cashing in on your investments, and you should build the loan payments into your retirement budget. If you intend to sell your former house quickly, you can use the money from the final sale to pay back the HELOC and put it toward the balance owed on the new home.
Find out the home equity line of credit amount you may qualify to receive with our credit calculator.
If your foremost ambition is to build that cabin in the woods or beachfront home you’ve always wanted, consider all the financial routes at your disposal. Seek out the input of professional financial advisors and ensure you make the best choice for you and your family.
This blog was originally published by Minster Bank in 2018 and was updated in 2023.
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