Typical new home construction financing is designed to make money for the banks. Similar to minimum credit card payments, they are designed to be paid off very slowly over a period of many years. With offers for second mortgages and refinancing there’s a good chance that many 30 year mortgage holders will never pay off their mortgages, any more than many credit card holders will ever pay off all their balances at once. There are ways around this trap which will result in a lifetime of debt, and huge loan payments.
Just as credit card programs offer incentives for paying off your credit cards each month, knowing full well that most people won’t, banks offer better loan options. The actually encourage better loans with lower rates, but they know human nature, and are quite confident that everyone is out to borrow as much as they possibly can for as long a period as they possibly can. They are right in their assumptions, and most people do exactly that.
You will need two loans in order to finance your home. One is a home construction loan, and the other is a mortgage loan. The home construction loan is really no big deal from an economic point of view. It is for the term of one year or less, during the time of construction. It is an interest only balloon note, with regularly scheduled withdrawals for construction costs.
The Mortgage loan pays off the construction loan, after fewer than 12 interest only payments, and usually more like six monthly payments in all. Therefore the terms of the construction loan are relatively unimportant, except for a larger required down payment for a construction loan than most mortgages. Most home construction loans require a 20 to 30 percent down payment.
Borrowing the remainder of the construction cost on a 30 year mortgage is very expensive, even at today’s record low interest rates. Most people today are paying about four percent interest on 30 year loans. Four percent is not bad, but paying on it for 30 years is, and here is why. Mortgages are based on amortization. Amortization is a means to divide your loan into equal payments.
This means that payments during the first several years include substantially more interest and less paid on the principle. For example, on a $140,000 loan at 4 percent, the homeowner will pay $2465 in principle and $5555 in interest during the first year. The following five years are very little different and by the sixth year the homeowner pays $3010 in principle, and $5010 in interest. After 10 years of making $668 in monthly payments the homeowner still owes $110,297. Despite already paying over $80K for their home they now owe only about $30K less than they did ten years ago. Over the course of this loan the homebuyer will pay $100,617 in interest.
Yes, there is a better way, and that way is a 15 year loan. While monthly payments on the same amount may be a little more, it is better to build a smaller more energy efficient home anyway, so perhaps if the payments are too steep on a 15 year loan you can reduce the amount of your loan. For the purpose of comparison though, we will compare a loan of equal amount and a lower interest rate. Interest on a 15 year loan is normally one percentage point lower than interest on a 30 year loan, so we will calculate at 3 percent in order to continue to calculate in round numbers. Current rates are in fact a little bit lower than 3 percent for a 15 year loan though. The bad news is that a loan in the amount of $140,000 requires a monthly payment of $966 per month, but the good news is that in the first year of the loan, you will pay $7,504 on principle, and only $4097 in interest. In ten years, you will only owe $53,805. Over the entire course of the loan you will have paid only $34,026 in interest.
It became fashionable during prosperous times, to borrow as much money as possible. The maximum you can borrow is the basis for the kind of homes that home builders and Realtors will show you. They just assume that you want to borrow as much as possible. You are not required to spend that much, it is just assumed that you want to. Once you see all the lovely home plans in your “price range” it is hard to step down when you learn about the price tag.
That is a very easy calculation. It is one third of your income, made in payments on a 30 year loan. Instead, tell your Realtor or home builder that you want to qualify based on 25 percent of your income on a 15 year loan. This may limit the amount you can spend, and if it cuts into your budget too much, ask how much you can borrow at one third of your income on a 15 year loan.
Suppose you make $40K each year and your spouse makes $30K that means together your income is $70K. Your combined monthly income is $5833. One third of your monthly income is $1944. One fourth of your monthly income is $1458. You could borrow $400K easily from the bank, but would your really want to pay $1944 each month? Can you afford a $171K down payment? More importantly do you really need a $570,000 home? Even more importantly do you really want to pay $685,759 over the next 30 years, including nearly $287K in interest? The answer to most of these questions is probably no, and yet your home builder may assume that you do, unless you advise them otherwise.
If you prefer, you can ask to prequalify for a 15 year loan at no more than one quarter of your income. What would that look like? You could qualify to buy a $300K home with a 90K down payment. The loan amount would be 210K. This is a much more sensible figure. You would pay only 51K in interest and be house payment free in 15 years.
15 year loans make a lot more sense than 30 year loans when you really look at them. You can save at least 100K in most cases with a sensible 15 year loan. Banks actually like to write 15 year loans, even though they make more off 30 year loans. They will be eager to sign you up because the risk for them is a lot less. For more information on new home construction financing download our 98 page free book, and read the many articles on this site.