How to finance home construction

If building a custom home or making an addition to your existing home is in your future, spend time on due diligence. Checking out your builder's suppliers and know as exactly as possible what amenities you want to include before you take out a construction loan, advises John Callahan, senior vice president of Cornerstone National Bank & Trust Company in Palatine.

Since the financial meltdown a few years ago, lenders are more discerning about how the loan is utilized in the construction process.

So, for example, if your construction plan calls for a fireplace and you decide during construction that you prefer more expensive kitchen cabinets and decide to forego the fireplace to get them, you could potentially affect the overall value of the end product, he cautions.

"It is better to nail down everything beforehand so you know that the allowances the builder is allotting for lighting, flooring, trims, etc., will adequately cover the items and finishes you actually want. If not, you need to have them adjust those allowances so you don't have massive cost overruns down the road," he said.

"The lending industry, including the secondary mortgage markets, has evolved and become more finely tuned as a result of the housing meltdown a few years ago."

Callahan said there are a lot of moving parts when you are building a home or home addition - and you have to keep all of the plates spinning simultaneously once you truly start the process. That is why he strongly advocates that a potential custom homebuyer do so much background work before ever signing on the dotted line.

Get a general idea about building costs in your community by contacting Marshall and Swift (www.marshallswift.com) and pay a fee to have them give you the cost basis for the size and type of home you are considering.

If the cost it gives you seems within your means, interview several builders and architects before making your choices and make sure you ask for and investigate their references, Callahan said.

Next, become familiar with the regulations of the community where you would like to build and make sure your builder and architect are also well versed in these requirements before the process begins.

Work closely with the architect to make sure living areas and the kitchen of the house he or she designs are exactly as you wish and will fit on the lot you own or have chosen. Then get a cost basis from the builder and find out exactly what his estimate includes in terms of flooring, lighting, plumbing and other finishing allowances.

"You should even go so far as to visit the builder's suppliers to see the products and finishes he is offering you. If they are not to your taste, go shopping for a different supplier, making sure that the prices quoted are competitive, or have the builder adjust your allowances and write them into the contract," Callahan said.

"If the builder gives you a cabinet package with a variety of finishes, go look at them and make sure you will be happy with them before you agree to that allowance. Too many people don't really know what they will get for their allowances and then they run into cost overruns, which can increase the construction costs by 15 (percent) to 20 percent," he said.

Someone planning for a big foyer, for instance, would need a big chandelier for it. Lighting fixtures like that could easily cost between $1,500 and $2,000. Homebuyers who aren't careful could easily blow most of their lighting allocation on that one fixture, Callahan said.

"In all the years I have been working in construction loans, I have only had two projects that have come in completely on budget and both of those borrowers were very resourceful and diligent about their budgets and researched their projects prior to construction," he said.

When you are finally ready to sign the construction loan papers, be sure you are very familiar with its impending impact on your finances and understand your choices when it comes to financial instruments and what will happen when it is time to convert the loan to a conventional long-term, fixed-rate mortgage.

Callahan and his colleagues make sure they carefully analyze with their customers the entire contract and look at all eventualities before the paperwork is signed. In addition, they want to know the borrower has 10 percent to 15 percent of additional available funds to cover any cost overruns that may arise during the project.

Do today's buyers of custom homes get bridge loans to finance their new homes?

"Bridge loans are available, but the intent is to "bridge" the construction period and the sell period for the existing home during the construction period. Prior to the real estate collapse, it was common to utilize this type of financing. However, bridge financing fell out of favor when it became more difficult to sell homes and people were worried about carrying two mortgages."

What are typical construction loan terms?

They are generally written for a period of one year and then are converted to an end loan upon completion of the construction project. Interest rates charged are based on the borrowers' equity but they are generally running about 5 percent today.

Cornerstone and most small banks offer borrowers a two-step process with a construction loan, followed by conversion to a mortgage. This allows for greater flexibility in the event there are changes to the project, Callahan said.

Larger banks often offer one-step loans in which the construction loan is automatically converted to a mortgage but these, he said, are very regimented and inflexible. So, the borrower has to start all over and pay points again if they need to add to the loan to pay for cost overruns.

How do you ensure that the general contractor pays his subcontractors and suppliers and leaves you with a free and clear title?

"We have a title company administer our construction payouts and they act as the liaison, paying subcontractors directly and getting lien waivers from them and their suppliers. This protects the homebuyer, the bank and the general contractor."

For more information about construction financing, call Cornerstone National Bank & Trust Company at (847) 654-3000.