A question many people who are thinking about building a new home on their own land is, "how much cash will I need as a down payment"? The answer, like many in life, is "it depends". What does it depend on? Here are a few answers that will hopefully help you as you plan your build.
The first thing to understand is there are two kinds of loans for buying or building a house:
- 1. a construction loan - the short-term loan from a bank you'll need to build, and
- 2. a permanent loan (we ususally call it a mortgage), the loan you'll need once your house is complete.
Differences of the two loans
The permanent loan is the one we all are familiar with, the one where you make a monthly payment to the mortgage company for 15 or 30 years (hopefully less if you can). You can't borrow money using a permanent mortgage for buying the land and building the home, so you need a construction loan, and there's a lot that's different about a construction loan. While this article deals with how the cash down payment is figured, you can read more about construction loans here.
Lenders are different
The next thing that's important to realize is that you'll be borrowing money from a different type of lender for the construction loan than you will for the permanent loan.
The construction loan will come from a bank, which is different from a mortgage company, because the bank likes to do short-term loans as opposed to the longer-term mortgage.
Yes, many banks have a mortgage company as well, but the difference in structure makes them actually different entities even though they might share a building and even a name. The bank will have a few different requirements than the mortgage company, in two main areas:
- 1. Debt-to-income ratio, which is simply the ratio of monthly loan payments you have divided by your monthly income. Banks typically like this ratio to be less than 43% or so.
- 2. Cash down, which is the amount of cash the bank wants you to put into the deal before they put their cash in.
We're going to talk about the cash you'll need for a down payment, why the bank wants that down payment, and how the bank comes up with the amount. Banks see construction loans as riskier than permanent mortgages, mainly because they are lending the bank's money, not selling the loan to investors they way mortgage companies do. Also, there's always the risk that the bank will get stuck with a construction loan if the customer isn't able to qualify for the permanent loan once the house is built.
The bank usually wants you to make a down payment of 20% of either:
- the cost to build
- the appraised value.
So, if the house appraises for more than the price to build the house, the bank will be lending you 80% of the higher amount.
Insider Tip: To potentially reduce the amount of cash you'll need, find a bank that bases their loan amount, and the cash down payment, on appraised value rather than construction cost.
In either case, in order to figure out how much cash you will need as a down payment on your construction loan, you will need to know the amount the house will appraise for. If the bank's loan amount is based on construction cost, they won't lend more than 80% of value in any case (imagine your cost to build is $200,000 and the house appraises for $195,000 - the bank will loan 80% of the lower number). If the bank's loan amount is based on appraised value, you'll need to know that appraised value to know how much cash you'll need. It's kind of a chicken-and-egg thing.
To summarize, here's the formula:
[Cash Down Payment = Construction Cost - Construction Loan Amount]
[Construction Loan Amount = Appraised Value X 80%]
You can see from the above that if your house to be built appraises for exactly the cost to build, you'll be able to get a loan for 80% of the cost, and you'll need the other 20% in cash. However, with a bank willing to loan 80% of appraised value (NOT just 80% of cost), if the appraised value is higher than the cost to build (which happens regularly), you'll be able to borrow more than 80% of the cost to build.
Your building contract with your builder is for $250,000. Let's say the appraisal comes in at $270,000. Your banker will lend you 80% of $270,000, which is $216,000, meaning you'll need $34,000 in cash ($250,000 cost to build minus $216,000 in construction loan). That's $16,000 less than you'd need if the house appraised for exactly the cost to build.
You need the appraised value
You can also see that in every scenario, the variable that you don't know up front, but need to know in order to answer the question of how much cash you need as a down payment on your construction loan, is the appraised value.
The only way to get that number is to do the appraisal.
If cash is tight, it might be worth it to you to go ahead and pay for the appraisal with the understanding that the $400 or so you spend is an investment in finding out whether you'll be able to make your dream happen now, or whether you'll need to put it off until you have more cash saved up.
If you only need to get a rough idea of the cash you'll need, simply use the formula of 80% of the cost to build, and don't worry about the appraisal yet, knowing that you'll be off a little bit depending on the results of the appraisal. If you need to know the exact number, get the appraisal done, and you'll be glad to have shed light on the unknown.
For more help on the whole process of going from raw land to finished house, download my free guide, From Raw Land to Forever Home.