New home construction loans can be daunting because they are so different from traditional mortgages. The lack of structure home buyers see in the process can lead to misunderstandings and costly and time-consuming issues in their new home construction.

Let’s talk about how these loans work, the common mistakes people make, and how to avoid them.

Construction loans are underwritten for the period it takes to complete the building project; usually a year. Borrowers get a line of credit up to a stipulated limit, and they submit draw requests to the lender at pre-determined times during the construction process. The loan payments are calculated on the interest for the current loan balance.

You can think of a construction loan like a giant credit card: you pay on what you owe, and there are no pre-payment penalties.

For example, if you’re given a $500,000 construction loan, you won’t start paying on it until your builder submits a draw request. If the first request is $50,000; you’ll pay interest on the $50,000 until the next draw request, when you’ll pay for the interest on the new balance.

That process continues until the home is complete, at which point you get a new loan for 30 years, or whatever term you choose, that pays off the construction loan, on which you make payments for the long term.

So what can go wrong in the construction loan budgeting?

1. Forgetting Your Loan Limit

People often get excited when they get their construction loan approval. They start planning in all the cool bells and whistles they could add to their new home without regard for the cost.

You’ll just have to spend more time and more money with your designer and builder to scale that plan back to fit in your budget. Be disciplined and clear on your budget and stick to it when creating and finalizing your plans.

There is no wiggle room to add on 5k here or 10k there for changes in plans. You’ll have to pay cash for those things! Again, remember your loan limit and plan carefully.

2. Forgetting Your Land Cost

You’ll have to check with your lender, but many construction loans can include the cost of the lot. However, and this is the difficult part, that land cost reduces the amount of money that can go towards the house construction.

The best-case scenario is owning the land free and clear, which can happen when you buy it with equity taken out of another property.

You don’t have to have the land to apply for the construction loan, but you do need to include the cost and sort out how to finance the entire deal.

3. Trying to be Your Own Contractor

It may look appealing to save some money by being your own general contractor, but here’s a bit of advice.

DON’T DO IT.

It’s the best way to guarantee huge headaches in your home building process.

Instead, thoroughly research and interview general contractors, and choose one that you trust and have good rapport with. You’ll be working closely with them for a year, and they are in charge of your huge investment and your future home, so choose wisely.

4. Ignoring Your Credit

If you decide to buy a new car after getting your construction loan approved, you’re changing your debt-to-income ratio, which can result in not qualifying for your permanent home loan.

Likewise, if you go on vacation and miss a mortgage payment that’s reported to the credit bureaus, your credit score will plummet, which can also disqualify you from your permanent loan.

Keep your credit picture the same during the entire process and be sure to avoid any late payments.

5. Not Planning for Contingencies

No matter how well you plan your new home construction budget; there will be changes along the way. Materials may go up in price, there may be theft or breakage, there might be surprises when the excavation starts, and maybe you will decide on some changes in materials or scope of work along the way.

Those things all mean more money.

Save yourself the hassle when those things happen and budget for them up front.

You Can Do This!

Knowing these major mistakes and planning for them ahead of time will keep the home building and budgeting stress to a minimum and ensure you get a house you love when it’s complete.