Is it Advisable to Build a House from a Loan to Pay Back in 20 Years or to Build with Your Personal Money Gradually?
When it comes to building a home, there's no one-size-fits-all solution. Two common approaches are funding the construction through a loan that you pay back over 20 years or saving up the money gradually. Both methods have their advantages and risks, and the decision ultimately depends on your financial situation and goals.
The Loan Option: A Construction Line of Credit
Building with a loan typically involves obtaining a construction line of credit, which is then used to pay for the construction and repaid with a mortgage on the completed house. While this method might seem similar to purchasing an existing home with a mortgage, it carries additional risks specific to new construction.
The loan comes with the risks of unforeseen costs, potential delays, and other issues that can arise during the construction process. However, if you secure a construction line of credit, you can manage these risks more effectively. Furthermore, once the house is completed, you can refinance the construction line of credit into a mortgage, making the payment process more stable and predictable.
The Gradual Savings Method: A Riskier but Potentially Rewarding Approach
Building a house gradually with your own money involves starting with enough capital to build a habitable structure and planning to add to the house over time. This can be a riskier approach compared to using a loan because it requires a clear and comprehensive plan. Without a thorough plan, you may face costly mistakes and redundant work.
The design and construction of a single residence is usually a single-phase project, but breaking it into multiple phases will increase the costs both in design and construction. Moreover, the opportunity costs of not having the money tied up in the house but rather invested elsewhere can be significant. For instance, money that could have been invested in a savings account might have earned interest over the years.
When a Gradual Build Makes Sense
If you can live in a home that is not yet complete for several years, a gradual build can be a great idea. During this period, you can make adjustments and improvements to the initial design as you gain more experience and insights.
Consider the scenario where you have the option to live in a home that is not yet complete for a few years. By building gradually, you can make necessary corrections and improvements before the home is fully occupied. This flexibility can save you money and headaches in the long run.
The Opportunity Cost of Waiting to Buy
There are significant opportunity costs associated with waiting to save up enough money to build a home without taking out a loan. A house that would have cost 200K twenty years ago might now cost 500K. This means that waiting to save could result in a much higher cost for the same home, and your savings may not keep up with inflation.
Consider the following example: you bought a 200K house with a 40K down payment and a 160K loan at 6% interest. If you sell today and pay back the loan, you'd have a profit of 300K. This amount covers your 192K in interest over 20 years plus an additional 108K. Instead of paying 800/month, you were effectively earning 450/month! In contrast, if you could only put your 40K in a savings account, you would earn only 200/month or less due to the low interest rates on savings accounts.
The extra 450/month you earned came from using Other People's Money (OPM). Not only did you benefit from the increase in the house's value from 200K to 500K on your 40K down payment, but you also earned on the lenders' 160K. This dynamic highlights the power of leveraging other people's money to achieve your goals.
Conclusion: When making the decision to build a house, consider both the loan and gradual savings options. Each method has its merits and risks. Carefully weigh your financial situation, future plans, and the potential benefits and drawbacks of each approach to make the most informed decision.
By understanding the financial implications and opportunities of each option, you can make a choice that aligns with your long-term goals and financial stability.