Many of our customers have questions about the best way to cover the construction costs for their new house. The good news is that several different payment and financing options are available, depending on your unique situation.
We've created this construction project finance guide to answer your construction financing questions. And, we share some personal insights about the land loan option that we chose for our prefab cabin build project here in New York State.
Please keep in mind that we're dealing with the laws and regulations of three different industries (real estate, construction, and finance), and their requirements can vary from state to state.
(Also, please note that this is not professional legal or financial advice, you should also speak with adequately licensed individuals in your area.)
Finance Options for Your New Construction Project
Whether you're looking to:
Add an ADU (Accessory Dwelling Unit) or more space to your current property
Build a home on property you already own
Purchase vacant property and build a custom home
You can choose from the following payment and construction finance options for construction projects:
Cash from savings
Refinance existing mortgage
HELOC loan (Home Equity Line of Credit)
There are pros and cons for each, and not every option will work with your specific situation. For example, if you're looking to purchase land and finance your new home construction, then a HELOC loan won't work for you.
Unless you plan to pay cash, here are the documents you will need for most loan programs:
Copy of closing disclosure from land purchase (if previously acquired)
Copy of recorded deed (if applicable)
Copies of bank statements showing the source of funds used to purchase land
Copy of contract to buy land. (If not already owned)
Copies of all estimates, contracts, and paid receipts for all work necessary to complete construction
Copy of plans and specs for the home to be constructed
Copies of W-2's or tax returns for the last two years
Copies of most recent year-to-date pay stubs documenting one entire month's earnings
Copy of most recent two years signed personal tax returns including all schedules (self-employed borrowers only, if applicable)
Copies of most recent two years signed business returns including all schedules (if applicable)
Copies of two consecutive months bank statements for all checking and savings accounts
Copies of most recent quarterly statements for any retirement and investment accounts
Proof of ID (state issued - such as driver's license or state ID)
We hear you. That's a lot of paperwork to compile, organize, and submit to get a construction loan approved. We suggest that you check with local credit unions and banks instead of "big name lenders."
You'll typically find competitive rates and fees, and you're working with someone who's not only in your time zone but local to the community, too. For example, we worked with Ulster Savings for our single close construction loan, which covered the property purchase and the construction costs for our first off-grid cabin build project.
Now let's run through a few possible construction financing options and help you decide the best construction financing solution for you.
We've included cash payments (from savings, investments, retirement accounts) because they can provide some unique benefits compared to a traditional loan.
Cash doesn't involve any submittal or approval process to begin work.
Cash allows for design changes or upgrades to happen on the fly. For example, most loan programs require an approved schedule of values as part of the loan approval process. Changing the costs might mean you have to requalify all over again.
Paying cash can usually get you a discount on materials and labor.
There are no interest or finance charges to pay for months or years down the road.
Before we jump to the loan programs, there are a few terms that you need to understand.
FICO credit score is your current credit score, which you can see for free at credit sites like CreditKarma.com
LTV stands for Loan-to-Value, or how much of your home's value you can borrow. So, if your home is worth $100,000 and the loan program has an LTV of 75%, the maximum you could borrow would be $75,000.
DTI refers to your Debt-to-Income ratio. You can calculate your DTI by adding all of your monthly recurring expenses together and divide that number by your monthly gross income. For example, if your bills total $2,000 and your gross income is $6,000, you have a DTI of 33%.
Down payment, some loan programs, like construction loans, do require a down payment in the amount of 20-30% of the total loan. Since the property hasn't been improved yet, the only collateral is the dirt and rocks on the property. On the other hand, some government-backed construction loans have a down payment of 0-5% of the total loan amount.
ADU is the real estate, and lender speak for our prefab plans and kits. In addition, there are specific ADU loan programs that consider potential revenue for loan qualification purposes.
OK, let's move onto the loan programs.
Refinance Your Mortgage
If you already have a home and are looking to add more living space, this could be an option for you. Even if you've only lived in your home for a couple of years, you have built up some equity.
Refinancing the current mortgage on your own home converts your equity to funds you can spend on your project.
The refi option can lower your current mortgage interest rate.
You may be able to skip a mortgage payment or two during the process.
And you only have a single mortgage payment each month compared to the HELOC loan, where you have a mortgage and HELOC payment due every month.
Here are the requirements to do a cashout refinance loan on your property:
- Home equity meaning your home is worth more than you owe.
- A credit score of 620
- DTI (Debt-to-Income) ratio of 36-43%
- LTV (Loan-to-Value) max of 75-90%
- A recent property appraisal
A HELOC loan
HELOC is an acronym for Home Equity Line of Credit. With the HELOC option, your current first mortgage remains intact. And the HELOC loan is a separate bill or payment due each month.
Here are the requirements for a HELOC loan:
- Home equity meaning your home is worth more than you owe.
- A credit score of 640 or higher
- DTI ratio of 43% or lower
- LTV maximum of 85%
- A recent appraisal may or may not be required
Interest rates on a HELOC loan are generally lower than personal or collateral-free loans.
Other perks can be no prepayment penalty.
Your original or current mortgage isn't affected.
Both the refi and HELOC are great options if you want to add space to your existing home for:
When family visit
More room for hobbies or exercise
Adding a dedicated home office or workshop
Earning a rental income stream
If the extra square footage is for business purposes, you might qualify for an SBA 504 loan.
If you already own or have purchased a property, you can qualify for a construction loan to cover the building costs for your dream home or retirement residence.
But a word of caution, first.
Construction loans are more challenging to obtain than other loans. Until the construction is complete, the lender's collateral is a patch of dirt and rocks.
To offset this risk, the interest rate for construction loans is higher, usually 1-1.5% above the current prime rate. And most construction loans require a down payment of 10-30%.
Most lenders require a schedule of values that assigns a value to each step of the building process. Then, as each step is completed and inspected, the appropriate funds are released for payment.
Most construction loans can be used for a one or two-family dwelling and also have an owner-occupancy requirement. The funds may be used to remodel, rehab, or do new construction work.
You can choose from various types of construction; you are not limited to a stick-built construction option. If your custom home is modular, panelized, a prefab kit, or even a log home, you're good to go with a construction loan.
You can choose a Two-Close term that offers 24-month interest-only payments. After the final inspection, the lender will refinance the loan to convert it to permanent financing (mortgage).
Or a Single-Close which offers interest-only payments for 12 or 24 months and automatically converts to a standard mortgage upon completion.
The LTV is determined by the property value and type of work being performed with the construction loan. New construction has an LTV of 80%, while a rehab/purchase and rehab/refinance option drops to 70% and 75%.
Property owned for less than one year is typically valued at the purchase price. Properties owned for more than a year usually require a new appraisal.
After submitting the needed documents, the lender begins the approval process by verifying your financials (remember that list above?), blueprints, work history, the property title, real estate comps, and your schedule of values.
After your loan package clears the underwriter's desk, it's time for signatures, and then you can begin building your cabin, cottage, or dream home.
As the construction progresses, the contractors and vendors get paid based on the pre-approved draw schedule. Unfortunately, draws are allowed for "completed work" only, so you can't pay the lumber supplier when the materials are delivered.
The lender's inspector will determine the percentage of work completed based on the schedule of values. Any applicable inspection fees will be deducted from the draw amount. Then, the lender will inform you of the work approved and the next draw or disbursement amount.
Your interest-only payments must be current, or your draw will be held until they are. Interest is typically billed based on the prior month's activity, so your first interest-only payment will be due thirty days after construction begins.
The lender can pay you or the contractor via check, money order, or wire transfer, depending on your preferences.
Once the construction is complete, the lender will need to close out the construction loan, which requires the title report, the building permit, and a final survey showing all the property improvements. You will also need to submit a current Builder's Risk or Homeowner's insurance policy before closing.
If your loan uses a Two-Close option, the construction loan closes out and gets replaced with a new mortgage loan.
If you're using the One-Close option, the construction loan automatically converts to a new mortgage loan.
To complete the permanent closing, you will need to submit:
Permanent Certificate of Occupancy.
A final certified survey that details all the work performed.
Convert the Builder's Risk to a Homeowners policy.
Update the title insurance with an endorsement or a final loan policy.
A final inspection report showing all the work is complete per the plans and specs and approved by the building inspector.
Yes, it seems like a complicated process, and it can be. But the process ensures that your dream home complies with local building codes and that everyone gets paid. Any unpaid supplier, contractor, or tradesperson can file a mechanics lien on the property.
Until the lien is paid and released, the property can't be transferred, sold, or refinanced. You can learn more about mechanics liens on our How to Find a Builder page.
The terms and down payment amount for land loans vary, depending on their intended use, local infrastructures such as roads, and utility services.
Predeveloped parcels, where utilities are easily accessible, typically require a 15-25% down payment. However, raw land is a greater risk for the lender and can require up to 50% down payment. Of course, you'll need to submit the financial and credit documents listed above to qualify for the land loan.
Rocket Mortgage, the largest lender in the country, stopped doing land loans this summer (June 2021). Most often, a local lender or credit union is a better choice for securing a land loan.
When you're ready to build, you will follow the construction loan process outlined above to construct your cabin or dream home.
Government-Backed Combo Loans
Another option is a combo loan through an FHA, VA, or USDA lending program. Each program offers a loan that covers the property purchase, construction costs and converts to a standard mortgage upon final inspection.
The beauty of these programs are:
- You only qualify for one loan that covers everything. You don't need to be eligible for two separate loans, land and construction.
- You only pay loan origination and closing fees once, not twice.
- Your mortgage rate locks in with the start of construction.
- DTI ratio of up to 50%.
- The required down payment is substantially less, usually 0-3.5%.
You can check with your bank or credit union to see if they work with:
If they don't, they should refer you to a local mortgage banker or broker who does.
Let's say you want to purchase a piece of property that costs $100K, and the house you want to build costs $200K.
If you went with the traditional land and construction loan option, you would have to come up with two down payments.
$15K for the property purchase (assuming 15%, could be more)
+$20K for construction loan (assuming 20%, could be more)
=$35K total down payments required
Using the same numbers as above for a combo loan option, $300K in total costs would require a maximum of 3.5% for the down payment. That works out to a total of $10,500.00 to cover the down payment requirement.
We want to help you make the best decision possible for financing your project, a cozy cottage, or that forever dream home. The best advice is to consider all the factors, requirements, costs, and timelines involved with the various financing options before making a final decision.
Before you go
As we were compiling all of this information for construction financing options, we stumbled across a relatively new program. If you're looking to earn an income by renting out your cabin or home, you might like this construction financing option.
This loan program is unique from other loans in that the lender will consider the rental income potential of the newly created apartment when reviewing a loan for approval. Some of the features of this loan include:
Maximum Loan Amount: Up to $200,000 or 97% of the property's combined loan to value, whichever is lower. Hard construction costs will be eligible.
Collateral: Second Mortgage / Deed of Trust
Repayment: Borrower is expected to repay the remaining principal balance and any interest due at the end of the 36-month term with a balloon payment
Monthly Payments: Interest-only payments for the first 12 months, interest and principal payments in months 13 through 36
Must work with a Qualified Builder per Housing Trust requirements
Tenant income restriction up to 120% of Area Median Income.
The borrower must lease the ADU at an affordable rate. Rent caps will be determined by the size of the ADU and will be updated annually.
Program partners include:
J.P. Morgan Chase
Shares Regis Foundation
Silicon Valley Community Foundation
You can learn more about this unique financing option at these websites: