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Step 1: Analyze Home Building Numbers

Take One
what you need to know
about construction financing
calculating the numbers
tax benefits of home ownership
getting yourself pre-approved
qualifying for credit
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What You Need to Know Upfront

  • Understand what it takes to build your home:

    are you really ready to build your dream?
    how much does it cost to build a new house?

  • Define the type of construction:

    1. Custom home construction:
      where the construction is based on a custom design and individually build for the home owner

    2. Production home construction:
      where the construction is based on 3-4 different "production" designs for a particular neighborhood. The homeowner may buy one of the plans from the builder and construct the house as specified. Some production plans allow for structural changes at additional costs.

    Understand the steps needed for a successful project:

    1. Can you afford building your home? Can you qualify for construction financing?

      These questions are reviewed in this file starting with: Calculating the Numbers.

    2. You need to define the project requirements. How many rooms, what is the square footage, how should the rooms adjoin?
    3. What kind of foundation do you need?
    4. You need to find the lot and neighborhood
    5. What kind of home style are you looking to build
    6. Need to search or custom design your house plan
    7. Need to setup the construction specification sheet
    8. Find a contractor to price the project
    9. Get bank approval for the construction project
    10. Manage the project
    11. Stay within budget
    12. Close on the construction financing / mortgage loan:

      Review house plans and other architectural plans online:
      see our Step 4 for our house plan directory

Notes: Home Construction Financing

  • What is a home construction loan:

    You will need to qualify for a construction loan before meeting with a builder. The construction loan will have a set limit that you can borrow (based on your qualifying ratios: see Step 5), which will determine the expense of your construction project in addition to the up front money that you will invest in the construction.

    There are basically two types of loans involved when constructing your home:
  1. Construction Line of Credit:

    This is a credit line that the lender setups on your behalf for the payment of contractors and supplies during the construction phase of your home.

    Cash disbursements may vary by lender. Typically, the first disbursement buys the land and then successive disbursements will be made when certain phases in the construction project have been completed.

    Most lines have a term of about 12-18 months, depending on the size of construction and area. Some lenders will offer an extension if needed, but often with up front penalties.

    You will pay interest on the amount that you borrow from the line during the construction phrase. The interest rate on construction lines are slightly higher than residential mortgage rates.

  2. Permanent Construction Loan (residential mortgage):

    At the end of the construction phrase, the line closes and the amount borrowed is paid off with a mortgage loan of your choice.

    Many lenders offer the combined construction line and permanent loan as a bundled product. There are advantages and disadvantages. See our discussion on construction/permanent loans.

    If you are unable to obtain the combined construction/perm loan with the same lender, you will need to:

    1. first qualify for long-term financing (i.e., mortgage loan) with one lender and then,

    2. meet with a second lender for the construction line of credit — these lenders will typically extend credit once you have the permanent loan arranged.

  • Up front Payment:

    Mortgage lenders expect owners to use a portion of their own money to finance their home construction. The standard percentage varies, but averages range from 5-10% or more of the home's future value (as determined by the lot, construction plans, and independent appraisal).

    Some lenders now allow for lesser percentages — as little as 3-5%, provided that you have good outstanding credit.

    Existing homeowners often use the equity value of their existing home as required up front money for construction loans. They may take out a home equity line of credit to pay the up front money or a percentage of the estimated construction cost.

    For more information about home equity lines: see our affiliated site at YourEquity.Com

    Note: IRS rules allow for an one-time distribution from qualified IRA accounts without the 10% penalty for acquisition of a home for first-time home buyers.

    See IRS publication 590 for information:

    We quote from the IRS web site:

    401(K) Plans

    Can I withdraw funds penalty free from my 401(k) plan to purchase my first home?

    If you are less than 59 1/2 years of age, you cannot withdraw funds from your 401(k) plan to purchase your first home without being subject to a 10 percent additional tax on early distributions from qualified retirement plans.

    However, depending on the rules for your 401(k), you may be able to borrow money from your 401(k) to purchase your first home. Your plan administrator should have written information about your particular plan that explains when you can borrow funds from your 401(k) as well as other plan rules.

    Topic 424, 401(k) plans


    If I can't withdraw funds penalty free from my 401(k) plan to purchase my first home, can I roll it over into an IRA and then withdraw that money to use as my down payment?

    Yes, if you are receiving a distribution from a 401(k) that is eligible to roll over into a IRA and you meet all of the qualifications for an IRA distribution for a first-time home buyer. Your plan administrator is required to notify you before making a distribution from your 401(k) plan whether that distribution is eligible to be rolled over into an IRA.

    To see if you qualify for a distribution to be used as a first-time home buyer, refer to Publication 590, Individual Retirement Arrangements (IRAs) (Including Roth IRAs and Education IRAs).

  • Discount Points:
  • Discount points are up front fees that lenders charge in order to offer you a lower interest rate on your permanent construction mortgage.

    A point equals 1 percent of the mortgage loan amount. For example, if the lender charges 2 points on an agreed loan amount of $100,000, your point fees will be $2,000.

    Many lenders offer mortgage loans with zero points. These products generally carry a higher interest rate.

    Typically, each point that you pay on a 30-year loan lowers your interest rate by 0.125 of a percentage point. This reduction may vary by lender.

    Compare rates vs. points calculation - from

  • Closing costs:

    Closing costs are incurred costs associated with the closing your home construction loan. There could be closing costs for the construction line and additional costs for the permanent loan, especially if you use different lenders for each product.

    These costs include lender fees, prepaid fees, title search, recording fees, surveyor's fees, attorney fees, and other closing-related fees.

    Closing costs can average about 3-5% of the total construction cost, including points.

  • Cash Reserve Account:

    It is highly advisable that you set aside a cash reserve account before starting your construction project.

    You may need this "extra" money for building deposits, cost overruns, construction changes and requested upgrades.

    There are too many "horror" stories of construction projects coming to a stop because of the lack of funds. Review Step 8: Managing Construction Costs.

    Many homeowners will use the equity value in their existing home to open a home equity line of credit as their cash reserve account. In the event of extra cash needed, they will draw upon their equity line account for cost changes.

    Caution: your existing home equity value may be needed to close on your residential mortgage. Make sure you run the numbers to determine how much equity can be set aside for your cash reserve account.

  • Add it up to estimate your up front payment and safety net in the event your construction costs exceed plan*:
  Total Savings:
  Total Cash Value of Investments:  
  Total Gift Monies and Other:
  Resale Equity Value of Existing Home:
  Expected Cost for Discount Points:
  Expected Closing Costs (minus points):
  Other Personal Costs (lot hunting):
  Amount Remaining for Down Payment /
  Construction Cash Reserve Account

Need a little more time to raise the necessary funds to do the job right? Link to our Budget Planning module for saving and expense reduction strategies: link to budget planning process.

* These calculations are based upon the assumptions you entered. Please note that rounding error may make a small difference in calculations. The accuracy of the calculation and the circumstances which you may qualify may result in different calculations.

Calculating the Numbers

Monthly Payment Calculation   Monthly Affordability Calculation
Enter the amount you want to borrow:
  Enter the amount you want to pay per month:
Enter the number of months to repay:
  Enter the number of months to repay:

Enter your estimated loan rate (APR):

%   Enter your estimated loan rate (APR): %

Your Monthly Payment

  Loan Amount to Borrow

Tax Benefit of Home Ownership

  • In most cases, you can deduct the mortgage interest portion of your house payment from your taxes, if you itemize your deductions on Schedule A (Form 1040).

  • The following calculation shows the estimated "Effective Interest Rates" for each income tax bracket. The "Effective Interest Rate" is the calculated annual interest rate that you will pay for the year after you deduct qualified mortgage interest from your taxes.

    You can also view our effective tax table for all income brackets.

Enter the average rate (APR) for home mortgages:

click here to view rates


Enter your income tax bracket:

Year 2003 Tax Brackets:

IRS 2003 Tax Rate Schedules


Your Effective Tax Rate: (1)


* Calculations are based upon the assumptions you entered. Please note that rounding errors can make a small difference in calculations. You need to consult your tax advisor for the applicability of tax savings.

IRS-related publications and forms for homeowners:

Getting Yourself Pre-Approved

  • You may want to pre-approve your construction mortgage loan before making construction plans. You will be able to design your plans knowing exactly how much you can afford.

  • There is no obligation when you pre-approve for a construction loan from a lender, nor does it obligate the lender to provide you a loan.

  • The pre-approval simply reviews your credit and income qualifications based upon the information supplied. The final approval will require verification of your financial status and construction plan.

  • We can help get your pre-approval application started. Search our financial network.

Qualifying for Credit

  • Lenders typically use two key criteria in qualifying you for credit:

    1. Your capacity to repay the mortgage loan
    2. Your outstanding credit report

  • Your capacity to repay your loan is analyzed by two lending ratios:
  • 1: The "housing ratio": calculated by dividing monthly housing expenses by your gross monthly income. As a basic rule, the housing ratio should not exceed 28%.

    2: The "debt-to-income ratio": calculated by dividing your fixed monthly expenses by your gross monthly income. As a basic rule, the debt ratio should not exceed 36%.

    There is more information about these ratios with a input sheet to calculate your own ratio: see our Step 7.

  • Your outstanding credit report lists any payment delinquencies that you may have had over the past three years.

  • The report can be a factor in a lending institution's decision to approve or decline your mortgage application. You should review your credit report for any errors before applying for a mortgage.

  • Allow yourself about 2-3 months prior to the loan application for correcting of any errors that may be on your report.

  • You have the right under Federal Law to know what is in your credit report.

  • We invite you to visit our Credit/Debt Management Center for complete information about:

    all about credit
    building and sustaining a good credit report
    applying and qualifying for credit

    what's in the credit report
    obtaining your FREE credit report for review
    making corrections to your credit report

    budget management
    reducing your monthly expenses

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