10 Tips for Building Your Dream Home - TheStreet

10 Tips for Building Your Dream Home

Construction loans can be a nightmare; we tell you how to avoid it.
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Whether you're considering the perfect retirement castle or simply want to avoid the lingering odor of a previous owner's ferret, there's nothing like moving into a brand-new house, where nothing needs to be painted or repaired.

Dream homes don't come easy. When I worked in the loan servicing industry, countless borrowers called to express their dismay with the construction process. The most common complaint was "they never showed up." That's because, during the housing boom, builders were trying to simultaneously run as many projects as possible.

Now that the housing bubble has burst, borrowers have a different problem: many small builders are going out of business. If this happens before your home is completed, you're headed for trouble. You may have to hire someone to do work you've already paid for. You could also be on the hook if the builder failed to pay a subcontractor. Either way, your building costs are going to mount.

Here are some tips to help to limit your risk:



Choose a building site carefully

. It may seem obvious, but there's usually a reason properties sell for bargain prices. For example, a lot abutting a highway may not actually be zoned for building. If you don't do your homework, you could be stuck with a useless lot. The real estate agent or seller didn't tell you? Tough luck. This may seem like a crazy example, but I've seen it happen!

Is the area mostly built up? If there are wide open spaces near your new home, you could be dealing with new commercial construction or a new school just around the corner from your new house. Enjoy the filth during the construction process. Then enjoy the traffic.



Research local building codes

. Depending on where your new home is being built, there may be special environmental factors to consider, such as flooding, hurricanes and earthquakes. Make sure that your builder addresses -- and even exceeds -- local building code requirements.



Obtain estimates for property taxes and insurance

. Depending on your situation and location, these items may represent a huge portion of your housing costs. Real estate agents and construction companies will do a very nice job in underestimating these costs when you are shopping for a lot.

The property taxes on the lot you are buying will likely be only a fraction of the fully assessed taxes after construction. Contact the county tax collector's office for help in coming up with the estimate. The taxes may be much higher than you expect, especially if you are moving from a different part of the country.

You should also contact an insurance agent early on to find out how much your homeowner's insurance will cost, along with any additional coverage you may need for hurricane, earthquake or flood damage.



Choose a builder carefully

. The most important factor in the success of a construction project is the integrity of the various contractors involved. The builder acts as the general contractor and is responsible for completing the project on time and within budget. The builder will likely employ many subcontractors to complete various important parts of the project, including framing, roof construction, plumbing, electric, etc. If a builder fails to pay a subcontractor, you will have a major problem on your hands.

So ask for extensive references, then make sure you contact them. Ask detailed questions. You should also inspect two or three homes that were constructed by the builder.



Manage subcontractor risk

. As I detailed

here, a builder's relationship with subcontractors is a huge risk factor. In order to make sure they are paid, subcontractors will place liens on your property. If the builder fails to pay a subcontractor, the lien remains, even if you already paid the builder for this work. So if the builder goes bankrupt, you could wind up paying twice for the same work. It is very important to get releases of liens from all subcontractors as they are paid.



Choose the lender carefully

. With construction loans, lenders don't just write a check to the borrower; they disburse a series of payments called "draws" directly to the builder as various stages of construction are completed. This means you, the borrower, are giving up your ability to hold back payment if you are unsatisfied with the work.

That's why it is important to choose a local bank with extensive experience in residential construction. As when choosing a builder, you should ask for references and follow up with detailed questions. You can also use

TheStreet.com Ratings Screener to check a lender's financial strength. An institution rated D+ or lower has a financial weakness that could affect your project.

If you feel it's important that you retain the ability to withhold payments for unsatisfactory work, you may want to consider alternative financing, such as a home equity loan or line of credit. If so, be prepared. You will have to take a very active role overseeing the project yourself.

Another alternative is an end loan. These are usually offered by larger builders. The big advantage is that you make no payments until construction is completed. In effect, you are purchasing a newly constructed home, built to order, without financing the construction. Another advantage is that the interest rate is usually lower than a regular construction loan. A disadvantage is that the loan documents usually require mediation or arbitration in the event the customer is unsatisfied with the finished home.



Make sure the lender is flexible

. For example, your construction loan documents may state that the project is required to be completed within 12 months. This means that you will have an "interest only" loan during the one-year construction period, after which your fully funded loan will convert to a regular mortgage with principal and interest payments. What happens if there is a delay?

Larger banks often charge a nonsense fee of 1% of the principal balance to extend the construction period. Right from the start, you should negotiate a construction extension agreement, stipulating how long the construction period can be extended and what the fees will be. If the fees are too high, choose another lender. Remember, because of the real estate slowdown, this is a


competitive business!



Watch out for hidden fees

. In addition to the extension fees described above, there will be other charges, such as inspection fees. The lender will inspect the construction site before extending the next draw. For a local inspection, the fee should range from $75 to $100. In a rural area, the inspection fee may be as much as $150.

A good way to manage this expense is to look at the draw schedule before you sign the loan agreement, and make sure the number of inspections is not greater than the number of draws. Another way to save is to consolidate a few draw schedule items into one site visit.



Carefully consider the loan structure

. Once your house is built, your construction loan will convert to a traditional mortgage. But you will have to decide on the ultimate structure of the mortgage right at the beginning, when you apply for your construction loan. This presents another set of potential pitfalls. I explain how to avoid the six most common mistakes




Consider a spec home

. If you've gotten this far, you might think you're in over your head. One way to find a great deal is to buy an already-constructed home. There is a major oversupply of newly built homes in many areas. A lot of people who speculated on real estate during the boom years are desperate to sell. With some effort, you just might find your dream house, already built, in a beautiful area, for a reasonable price. Your only problem then will be selling your current home!

Philip van Doorn joined TSC Ratings as a banking analyst in February 2007. He has a varied background, with a B.S. degree in business administration from Long Island University. He previously worked as a loan operations officer with Riverside National Bank in Fort Pierce, Fla. Before that he was a credit analyst, monitoring banks and thrifts at the Federal Home Loan Bank of New York.