Use a construction loan to build your dream home
Many people dream about building an owner-occupied home. However, before construction can begin, you have to answer the question of how to finance the construction. In most cases, the answer lies in a construction loan from a bank. Construction loans offer a high degree of flexibility and a clear overview of all costs for building a home on credit.
Construction financing is different than a mortgage
Living within one's own four walls – This is a dream that many people would like to realize at some point in their lives. Perhaps a purchased home cannot fulfill all your individual requirements. If you don't want to compromise, you can decide to build a new home or to undertake extensive renovations. That costs a pretty penny, however, and is often impossible to finance without borrowed capital.
The solution? A construction loan. Unlike a mortgage, the sum that is paid out is not fixed. The builder-owner and the bank simply agree on a maximum credit line for a special account that covers the ongoing construction costs. Because the credit must ensure financing for the entire property, it is important for the builder – together with the bank – to create careful and detailed calculations in advance.
Constructions loans maintain a low interest burden for a long time
However, you cannot finance the construction of an owner-occupied home without using any equity capital. The builder-owner must contribute at least 20 percent of the total sum from their own funds and deposit these funds into the construction account before any work can start. The equity capital is used to settle costs that arise during construction. The construction loan is used only after the equity capital has been completely exhausted.
Unlike a mortgage, the loan amount is not fixed. Instead, it is flexible. This is the main advantage of construction financing. The bank charges interest only on the amount that has already been taken as credit. In return, however, the interest rate charged is relatively high. Normally, it corresponds to the interest rate of an adjustable-rate mortgage plus a commission fee.
Construction loans are earmarked
The capital from a construction loan is not freely available. It is earmarked for the entire term of the financing. The money can only be used to cover costs incurred for the home. To ensure this, the bank itself processes all payments made via the construction account.
The builder-owner has no access to the account. They must send the bank all of the invoices they receive from craftsmen and architects for work on the house. This procedure has benefits for the builder-owner as well: It eases the burden on them and simplifies cost control. This is important because it is difficult to consider all the costs of a new construction, even with the best planning.
The construction loan is consolidated once construction is complete
You no longer need a construction loan once the house is finished. Consolidation is now possible. Typically, after construction is finished, the bank converts the entire loan into a mortgage, at your choice. The mortgage is subject to the regular rate of interest and must be amortized if the equity capital comes out to less than one-third of the total cost.
However, full consolidation at the end of the construction phase is not the only available option. If the interest rate for the construction financing is considerably higher than the mortgage interest rate, a partial consolidation before construction is completed may be financially worthwhile. However, the mortgage may not be higher than the amount of the construction loan that has been claimed up to that point. If you talk to your client advisor at an early stage and make precise calculations, you may be able to benefit from a lower interest rate.
How construction financing works using a construction loan and full consolidation
In the initial phase of construction, the equity capital must be used up first. Only then do you take advantage of the actual construction loan. Once construction is completed, the loan debt is converted into a mortgage.
Source: Credit Suisse
Find the right construction financing
Each new build or renovation is unique and has different financing requirements. It may be worthwhile to compare various construction financing solutions. There may be stark differences in interest rates, the maximum term, the minimum amount, and the construction project requirements. You should think carefully before making a financing decision. It lays the foundation for the entire project. With the optimal solution, your dream of home ownership will soon be within reach.
