Before you decide how much cash you need for your project, before you go to the bank for a construction loan, you are going to have to come up with a preliminary budget. In a nutshell, you are going to have to balance out the cost of your home with what you can afford.

It's sometimes tough to know how to approach this. You don't know if you can afford your home until you design it, but you don't know what to design until you know how much money you have to spend. It's a bit of a "chicken-and-egg" dilemma, best solved by looking at the two issues separately. We recommend that you start off by taking a good hard look at your finances and cash flow.

If you use a financial advisor or a certified public accountant, now is a great time to give them a call and get them on board with your project. When coming up with a budget for your project, here are the main things you need to consider.

• How much cash you have access to and are willing to devote to the project. This would include cash in your savings, as well as cash you have access to through home equity loans, 401K plans, etc.
• Your current tax bracket.
• Any capital gains issues.
• Tax deductions for interest and points.
• How long you intend to own the home.
• Your other monthly financial obligations.

Taking all of this information into account, the goals right now is to come up with a monthly payment that you can handle comfortably. Once you have arrived at this figure, you can use a mortgage calculator to translate it into a loan amount. These calculators are pretty easy to find online. Just try doing a Google search, or go to www.mortgage-calc.com.

Take this loan amount and add it to your cash on hand. You now have a basic budget to work from. Remember, this budget is not only for the house, but must also include land purchase, permitting fees, architect and contractor fees, decorating costs, and landscaping fees, to mention just a few of the more obvious costs associated with building a home.

Why Having Cash On Hand is So Important

Okay, a few pages from now we are going to get into some really detailed information regarding getting your construction loan. So if you are planning on getting a loan anyway, why are we talking about how much cash you have right now?

When you get right down to it, the answer is pretty simple. Sure, your construction loan will cover a good portion of your home building costs. However, there are lots of rules and regs concerning your construction loan, and sometimes it takes a little while to get the money you need. Having cash on hand will ensure your project doesn't come to a screeching halt while you deal with red tape.

You'll need cash for things like the downpayment on your land, permits, closing costs, moving, landscaping, and decorating. Most of all, you'll need some cash on hand if something goes wrong-say your contractor skips town or materials costs unexpectedly go up-as well as for upgrades you'll want once the home building process is underway.

Of course, it's not enough to just have cash. You need to manage it, too. There are many online resources that can help you get a good start on managing your money. Eventually, you'll want to find a good financial planner who can help you manage your investments and ensure that your works for you and your cash is put in a situation that allows it to grow.

In the end, building a home is a risk. You never really know exactly how much your home is going to cost until it's done. Your estimate is a guess only. You also need to know that you have no control over economic conditions-whether your house will hold it's value or whether interest rates go up or down, for example. Make sure you can handle risk by being aware of worst-case scenario. Have a game plan should your worst-case scenario come to fruition, and never get in over your head so that you can't handle, or recover from, things that have the potential to go wrong.

Construction Loans

It seems like every time you turn on your computer and check your email these days, there's another message from a home mortgage company trying to entice you with lower rates or a new product.

If you've bought a home or homes before, chances are you know a bit about how home mortgages work. Well, put all that aside for now. When you are building a custom home you have to get something called a construction loan, and construction loans work very differently from normal mortgage loans when it comes to pricing and structure.

One of the most noticeable differences of a construction loan is that the bank doesn't give you the money up front, all at once, the way it does with a home mortgage loan. Instead, the bank gives you the money depending upon where you are in the construction process. Why do they do this? In order to protect themselves as much as possible. If the construction process is halted for any reason and building is not able to continue, the bank doesn't want to have to recoup the amount of money the finished home would cost.

Because banks tend to structure their construction loan products based on their needs, there is not the same type of regulation when it comes to construction loans as there is with home mortgage loans. This can sometimes make them hard to compare. Despite that, all construction loans fit into one of two categories. They are either single-close, or double-close.

The Double-Close Process

Until the 1990s, this was the only way to get a construction loan. With this type of loan the bank gives you a short-term loan designed to last through the construction process. Once construction is complete, you have to secure permanent financing through a home mortgage product.

Of course, now that there is another option (which we'll get to in a second), there are reasons why this type of land loan is becoming increasingly unpopular. First of all, you have to go through the entire application and qualification process twice, and why do that if you don't have to? Second, the double-close process is almost always more expensive because you have to pay for costs associated with two loans. And finally, there's no feeling of security with a double-close loan. The economy at the beginning of the loan process can be completely different by the time construction is complete and its time to apply for another loan. In a nutshell, you really have no good way of knowing whether you or the house will qualify for another loan when all is said and done. It is possible that a change in interest rates, or in the economy, will have you facing payments you can't afford. Or even worse, foreclosure.

The Single-Close Process

Single-close construction loans have been around since the 1990s, and is the option you should go with unless for some reason you don't qualify. These loans go by many different names, including All-in-One, Construction/Permanent, One-Time-Close, and Construction-to-Permanent. These loans were created by larger banks when they realized that people who live in homes they have built themselves default on their loans less and live in their homes longer. By offering an all-in-one loan package, these banks are securing good long-term customers, which is profitable to them.

Single-close loans generally have the following features:

• Once your construction is done you roll into your permanent loan automatically with no re-qualification or re-appraisal process.
• You can choose from a wide variety of permanent loan options depending upon your needs.
• Sometimes you can even buy land and roll that into the loan as well, assuming all the construction documentation is ready.
• You may be able to lock in a good interest rate before the house is completed.

Single-close construction loans make the loan process, indeed the home building process, easier on the consumer. They are a great way to go, especially if this is the first time you've undertaken a home building project.

How to Choose Your Construction Lender

The first thing you should know when looking for a good construction lender is that not a lot of lenders have experience in this field.

To that end, going through your neighborhood bank is not always the best idea. You want a lender with lots of know-how and experience, and you might have to do a little homework in order to find one.

If at all possible, look for a lender who is an expert in construction loans. And make sure that your lender has your interests in mind when selling you a product. Lenders are salespeople-no doubt-but they should be willing, and able, to sell you a product that is good for you.

It's hard to determine whether a particular lender has your best interests at heart, especially if you yourself don't have a lot of experience or knowledge of the product. To that end, we suggest you educate yourself. We also suggest that you really screen potential lenders. If a lender tries to sell you something without asking lots and lots of questions regarding your particular situation, then steer clear.

We also suggest that you ask your potential lenders lots of questions about the construction loan product to determine the extent of their knowledge. The lender should either know the answers without batting an eye, or he or she should be willing to research the answers. One of the questions you should ask is how many construction loans your lender has personally done. Try to go with someone who has done at least a dozen.

Some mortgage lenders act as construction loan consultants and can guide you through the entire process, from A to Z. They commonly sit down with you, assess you situation in detail, and then come up with the best possible program for you. The fees for these consultants can be somewhat more than other lenders, but their experience can save you lots of time and money in the long run. Also, it's tough to put a price on the peace of mind you'll having knowing you are working with an expert who knows all the answers. Which brings us to the next question.

Should You Cut Out the Middleman?

Well, in theory it sounds like a great idea, doesn't it? But in reality, Cutting out the broker and going directly to the bank probably won't save you money in the long run. As a matter of fact, you might end up spending more money, The goal here, the one that will have the best long-term rewards for you, is to find the program that works best for you. When you consider that bank loan officers are often the most inexperienced in the business, not to mention the fact that banks are limited by the products they have (none of which might be right for you), cutting out the middleman all of a sudden doesn't sound like that great an idea.

So, let's focus on some reasons why it's good to find a broker. First of all, brokers are very experienced. They spend their days contrasting and comparing programs, so the odds of them finding one that's right for you are pretty good. Mortgage brokers also have access to every program out on the market, which means that once you find a broker you like, you can do all the shopping you want. Finally, mortgage brokers can help you when it comes to presenting yourself to the bank in the most favorable light.

The Loan Process

Before you submit your application to the bank, you should have already purchased your lot, have your finances in order, including knowing what you can afford and what your budget is for the project, and your plans should already be submitted to the building department.

Did you know? In most cases, you won't have to sell your current house in order to finance your new house. Most banks don't take the cost of your current home into consideration when calculating your loan amount. Discuss with your financial advisor the benefits of refinancing your existing home at this time. Taking the highest loan possible at the lowest payment will keep your monthly payments low, while also giving you access to extra money. Worried about paying for two homes at once? Don't be. Most construction loans have something called an interest reserve, which covers the construction loan payments.

Make sure you time the loan process correctly. You have about 90 days after you sign the loan to fund it. If you don't do things within this time period, you'll have to spend additional time and money getting a new credit report and appraisal. When is the best time to submit your paperwork for a construction loan? About 60 days before you are ready to start building. Since most building departments take about a month and a half to review your plans, a good time to begin the loan process is when you submit your drawings.

Paperwork, Paperwork, and More Paperwork

You'll kill at least a few trees with the amount of paperwork you need to fill out. To that end, it's a very good idea to have one file or folder in which you keep it all. That way, if you need to get your hands on something quickly, you'll know exactly where to go.

Here's what you'll need:

• Application, which includes all of your personal and financial information.
• Consent form, which allows the lender to verify the info on your application.
• Signed disclosures.
• Two most recent pay-stubs.
• Two years worth of W-2s.
• Two years of your tax returns.
• Three months' bank statements on all accounts.
• Recent retirement account statement.
• Land purchase closing statement.

In addition, lenders will also want the following construction-related documents before they review your application:

• Three sets of plans.
• Cost breakdown supplied by contractor.
• Description of materials form, also supplied by contractor.
• Builder statement
• Construction contract.
• Architect information.
• Insurance information.
• Contractor's liability policy.
• Workers' compensation policy or waiver.
• Course of construction policy.
• Copies of permits or permit applications.
• Copies of receipts for any items or work that has been done thus far.

To Lock or Not to Lock?

Many construction loan programs don't allow you to lock the interest rate in. After all, the banks don't know what the interest rates are going to be in 6 to 18 months any more than you do. Understand that if you do find a program that allows you to lock in the rate, it's going to be somewhat higher than that day's refinance rate. Which is fine as long as the market gets worse during your building process, but how can you determine whether or not this is going to happen? The answer is, you can't. You are going to have to work with your loan officer to decide whether or not to lock, if that is an option, and even then you have to accept that, really, you are just guessing.

Do I Want a Short-Term Loan, or a Longer One?

Well, for all intents and purposes all construction loans could be called short term. Most range in length from six months to 18 months. You'll get a better rate for a six-month loan than you will for an 18-month loan. But, while it might be enticing to go for the shorter loan with the lower rate, any number of things can cause your construction project to drag on. And what happens when you go over your construction loan time limit? You get zapped with penalties. And the penalties can be very, very expensive. You are much better off making a conservative estimate when it comes to how long your house will take to build-and then tacking on a few extra months if you can as a safety measure.

What Your Loan Will Cost

There are lots of fees attached to your loan, and you are probably wondering what they all mean. Where are these fees listed? You can find them on the Good Faith Estimate provided by your lender. Here's the lowdown on where all your money is going:

• Points. These are upfront fees equal to one percentage of you loan amount charged to either generate cash or reduce the interest rate.
• Escrow and title fees.
• Appraisal fees.
• Insurance on your construction loan.
• Administration and inspection fees.
• Credit report fees.
• Funding and underwriting fees.
• Processing fees.
• Recording fees.
• Tax service fees.

Wow! And there are sometimes more. Roll all of these together and you get what are called closing costs. The point is you need to take all of these things into consideration when budgeting. You can pay for these things up front with cash, or in many cases you can roll them into your loan.

Did you know? You'll need proof of one or more types of insurance before your lender hands over the funds. First of all, you'll need a liability policy designed to protect you if someone, authorized or not, gets hurt on your build site. Your lender will also want to see your contractor's workers' compensation policy if her or she employs people. You also may need a Course of Construction policy, which protects you in case of fire, theft, weather, or other damage to the house during the building process.

In the End, How Much Loan Do You Need?

How much loan will you need? Figuring out the final number is pretty easy, when all is said and done. You'll need to add up the cost of your land, soft costs (planning, design, permitting, and fees), hard costs (all costs associated with construction, including labor), plus your emergency fund (some money set aside for anything that might go wrong. And something always does!). Add your interest reserve, plus you loan closing costs, and now you are ready to total up how much it is going to cost you to build.

Once you have a fairly good estimate of your project's cost, it's easy to figure out how much of a loan you need, as well as how much cash. Lenders will use both the appraisal and the cost to build to figure out how much of a loan they are willing to give you. Some will base the loan on finished value, while others will base the loan on cost to build. Lenders will loan between 65 to 90 percent when doing it on a finished value basis, while a cost to build loan is almost given at 100 percent. In the first case, you'll just have to do some simple math to figure out how much cash you need. Just take the cost to build and subtract the maximum loan amount, and that's how much cash you'll need for the loan.

How Your Construction Loan Works

s soon as someone picks up a hammer, you are going to have to open your checkbook. But how does the money get from the lender to your contractor? Hold on, and we'll explain.

As we've mentioned many times, construction loans are very different from mortgage loans. And one of their most obvious differences is that you don't get all of your money up front. Instead, you get the money depending upon where you are in the construction process.

You and your contractor must come up with a detailed construction budget. Based on this, the lender will come up with a loan-in-process (LIP) account. This account will have every item in your budget in it. After a particular job is completed, you support proof of payment in the form of a receipt and the bank hands over the funds.

This type of draw system is managed on a percentage of completion system. In other words, on the amount of your home that is finished.

Did you know? All construction loans have what is called a contingency. This is money set aside in case you go over budget.

Don't expect the bank to take your word that the project is running as planned. At several points during the process they will send out what is called field inspectors-people who will visit your build site to check out your progress.

The inspectors aren't looking at the quality of the work; they are just there to determine that the project is progressing as you say it is. Make a point of walking the project with the inspectors, and always be courteous and friendly.

Most lenders will insist that five to 10 percent of the hard costs remain in your account until your home is completed. You can access this money, and therefore complete your loan, by handing in the following paperwork:

• certificate of occupancy
• final draw request
• copy of homeowners' insurance
• final progress inspection
• statement from contractor saying you have paid him and all subs in full
• verification from the title company that there are no liens on the property.