What I Learned About Mortgages When Building a House

When my husband and I started our search for a property in 2010, we ultimately determined that building our own home was our best course of action. We quickly found a builder we loved and were ready to get started. Of course, like most Americans, we needed to borrow money to cover the costs of our house -- and that's where the process got complicated.

As a personal finance writer, I've long been familiar with the process of getting a mortgage. But I was still surprised to discover that there's a whole added layer of complexity when you need a loan for building a home rather than buying a finished house. The challenges arise because you need to come up with money during the construction process, before your home is completed.

There are two different ways you can approach this problem: You could do a construction-to-permanent loan or you could take out a stand-alone construction loan. We chose the second option because of some advantages of this approach -- but it also created a lot of challenges along the way.

A construction-to-permanent loan is the easier solution

One of the simplest ways to fund construction on a new home is a construction-to-permanent loan. This is a loan you take out to fund construction that converts to a permanent mortgage after your home is complete.

With a construction-to-permanent loan, you'll put down 20% up front of the expected value of the future home, and you can borrow up to 80% of the future home's projected value when finished. When your home is completed at the end of the process, the lender converts your construction loan to a standard home loan after an inspection of the home.

Lenders typically allow you to pay interest only during the construction process with a construction-to-permanent loan, which makes payments very affordable. This can be important if you're paying rent or a mortgage on an existing house and don't want to make big payments while your new home is being constructed.

The problem is, the lender takes on a lot more risk with this type of loan because they're promising to lend you money on a home that's not yet completed. There's no guarantee the finished home will actually be valued at the expected amount, so you may end up owing more than the home is worth.

Because of the enhanced risk to the lender, interest rates on a construction-to-permanent loan are usually higher than interest rates on a typical mortgage, which is why we opted against this approach. We didn't want to get stuck with higher mortgage rates on our final loan for the many decades that we plan to be in our home.

A standalone construction loan is another alternative -- which has some benefits

Instead of a construction-to-permanent loan, we opted for a standalone construction loan when building our home.

This meant we took out a construction loan to fund the cost of the build. Then when the house was finished, we had to get an entirely separate mortgage to repay the construction loan. The new mortgage we obtained at the close of the building process became our permanent mortgage and we were able to shop around for it at the time.

Although we put down a 20% down payment on our construction loan, one of the benefits of this type of financing, compared with a construction-to-permanent loan, is that you can qualify with a small down payment. This is important if you have an existing home you're living in that you need to sell to generate the money for the down payment.

The loan is also an interest-only loan during construction, just as a construction-to-permanent loan is.

However, the big difference is that the entire construction mortgage balance is due in a balloon payment at the close of construction. And this can pose problems because you risk not being able to repay what you owe if you can't qualify for a permanent mortgage because the house is not valued as high as expected.

There were other risks, too, besides the possibility of the home not being worth enough for us to get a loan at the end. Because our rate wasn't locked in, it's possible we might have ended up with a costlier loan had mortgage interest rates risen during the time our home was being constructed.

We also had to pay two sets of closing costs and fees and go through two closing processes. This was a major hassle and expense, which needs to be taken into consideration when deciding which option is best.

Still, because we planned to stay in our home over the long term and wanted more flexibility with the final loan, this option made sense for us.

Borrowing to build a home is different than borrowing to buy a home

When borrowing to build a home, there's another major difference from purchasing a new home.

When a home is being built, it obviously isn't worth the full amount you're borrowing yet. And, unlike when you purchase a fully constructed home, you don't have to pay for the house all at once. Instead, when you take out a construction loan, the money is distributed to the builder in stages as the home is complete.

We had five "draws," with the builder getting paid by the bank at five different times during the construction process. The first draw occurred before construction began and the last was the final draw that happened at the end.

At each stage, we had to sign off on the release of the funds before the bank would provide them to the builder. The bank also sent inspectors to ensure that the progress was meeting their expectations.

The different draws -- and the sign-off process -- protect you because the builder doesn't get all the money up front and you can stop payments from continuing until problems are resolved if issues arise. However, it does require your involvement at times when it isn't always convenient to visit the construction site.

You could run into trouble if your finished home doesn't appraise for enough

There's another big issue you could run into when it comes time to get a final loan to pay off the construction loan. The issue could arise if your home doesn't appraise for enough to repay the construction loan off in full.

When the bank initially approved our construction loan, they expected the finished home to appraise at a certain value and they allowed us to borrow based on the projected future worth of the finished house. When it came time to actually get a new loan to repay our construction loan, however, the finished home had to be appraised by a licensed appraiser to ensure it actually was as valuable as expected.

We had to pay for the cost of the appraisal when the home was completed, which was several hundred dollars. And, when we initially had our finished home appraised, it did not appraise for as much as we needed to pay off the construction loan. This can happen for many reasons, including falling property values and cost overruns during the building process.

When our home didn't appraise for as much as we needed, we were in a situation where we would have had to bring cash to the table. Fortunately, we were able to go to a different bank that worked with different appraisers. The second appraisal that we had done -- which we also had to pay for -- said our home was worth more than enough to provide the loan we needed.

Before you build, research construction loans

Ultimately, we're very glad we built our home because it allowed us to get a house that's perfectly suited to our needs.

But, the construction loan process was a costly and complicated one that required us to put down a large down payment, to spend a lot of time dealing with securing financing, and to incur significant costs to pay for two closings and have multiple appraisals done.

Be aware of the added complications before you decide to build a home and research construction loan options carefully to make sure you get the right financing for your situation.

Still have questions?

Here are some other questions we've answered:

• Home Appraisals: What to Know, How Much It Costs, and How It Works
• Down Payments: What They Are & How They Work
• Starter Homes: What Are They and Is One Right for You?