Designing and building your own home is one of the best ways to ensure that your dream home is exactly what you envisioned. A home construction loan can help you accomplish your goals, but it’s important to be aware of some of the quirks associated with construction loans.
Here’s what you need to know about how to get a construction loan.
What is a construction loan?
A construction loan is a type of loan that is specifically used to finance the construction of a new building or the renovation of an existing one. It is typically a short-term loan that is paid off when the construction project is completed.
How do construction loans work?
Construction loans are typically given as a line of credit that the borrower can draw from as needed during the construction process. They are short-term loans that may come with higher interest rates than traditional mortgages. Most of them are meant to be paid off within a year.
Home construction loans are usually disbursed in “draws” to the builder or contractor, rather than sent to you. Each draw is disbursed as certain milestones are met. For example, your contractor might receive a disbursement after the foundation is poured, and another might come after the home is framed. All the terms are outlined in the paperwork.
3 Types of Home Construction Loans
There are three main types of home construction loans: construction-to-permanent, construction-only, and renovation.
With this type of home construction loan, once the home is built, the loan converts to a permanent mortgage. You typically only have to pay closing costs once, which can save you money.
You can also choose to pay interest during the building phase. However, it’s typically a variable interest rate, so your payments will fluctuate. After the home is built, and your construction loan converts to a permanent mortgage, you might be able to choose whether you want a variable rate or a fixed rate.
You may want to consider this type of loan if you have a feasible plan for your house’s construction, and you want to pay it back over time with a reliable monthly payment.
When you opt for this type of construction loan, you’re not going to have it automatically converted to a mortgage. Instead, you need to pay off the loan at the end of construction. As a result, you’ll pay two sets of closing costs, and have to get approved for two separate loans.
However, you might be able to make a smaller down payment on a construction-only loan than you would need for a construction-to-permanent loan. So, if you already own a home, you might want to get the construction-only loan for now. Then, wait until you sell your current home to get a bigger down payment for your mortgage.
Construction-only loans can work well for those with limited capital available now, but who expect to have money available later. Once the building is done, you can apply for a mortgage large enough to pay off the loan.
The downside is that if something happens to your financial or credit situation during the construction phase, you may not qualify for a mortgage large enough to repay the loan. Then, when your loan becomes due, you have new problems. This includes the possibility that you could lose your home before you even move in.
Renovation Construction Loan
Rather than helping you build something new, a renovation loan is designed to help you cover the costs of a major remodel. If you want to turn a fixer-upper into the home of your dreams, but aren’t sure if you have the money for renovations, this type of loan can help.
It’s important to note that these aren’t home improvement loans. A home improvement loan often deals with smaller remodels and is based on how much equity you currently have in the home. Renovation construction loans are about major overhauls.
Typically, you’ll get a loan big enough to cover the costs of renovations as a mortgage. You only apply for one loan, and it’s based on the likely value of the home after the remodel is finished. This can be a big help if you don’t want to try to finance the cost of upgrades after you buy the house.
What is covered in your construction loan?
In general, you’ll find that most construction loans pay for various aspects of a project, including:
- Obtaining the land (or the fixer-upper if you’re getting a renovation loan)
- Getting the plans for the home
- Applying for the permits
- Paying the fees associated with construction
- Contingency reserves for covering unexpected costs
- Closing costs
You might also be able to have interest reserves built into your construction loan if you would rather not make interest payments while your home is being built or renovated.
The idea is that everything you need to complete your home, whether new-built or a renovation, is wrapped up in the loan.
Create a Plan for Your Custom Home
When building a home, you can’t just ask a lender for an appraisal or just get approved for a certain amount. Construction loan lenders expect to see a plan for the construction of the home.
When you apply for a home construction loan, you’ll need to let your lender know the following information:
- Size of the home and the lot
- Placement of the lot
- Home plans (possibly include blueprints)
- Materials used to build the home
- Types of renovations you plan to make (for an applicable loan)
- Timeline for completing the home
- Contractors that will be hired
Lenders will dig into this information to decide if you’re a good risk. They want to know that the home, or the lot, will at least be worth something if you default on the loan. Part of the process is understanding that the home will at least be worth what you’re borrowing once it’s finished.
At each stage of construction, and before disbursement is made, the work will have to be inspected. If you choose a general contractor that’s experienced and respected, they can help you provide needed information to your lender, and you can be reasonably assured that they will do good work.
Qualifying for a Home Construction Loan
Now that you have a plan for your new home, it’s time to qualify for your construction loan. In many ways, the process is the same as qualifying for a traditional mortgage loan. The construction loan lender will review your financial situation and decide if you present a relatively low risk. Some of the things that a construction loan provider looks at include:
- Credit score: This is the most important element of any home loan, and it’s no different with a construction loan. In fact, because there might not be anything of tangible value before construction, you might need an even higher credit score. You typically need a minimum credit score of 680 to qualify, so you need to improve your credit score if you’re not there yet.
- Debt-to-income (DTI) ratio: As with a regular mortgage, the lower your debt-to-income ratio, the better off you’ll be. Most lenders require that your DTI be no more than 45% of your gross monthly income.
- Down payment: While you might be able to get by with 5% or less for a down payment with a traditional mortgage (FHA, USDA, and VA loans famously come with much lower down payments), a construction loan is a different story. You’ll likely have to put down at least 20% to make it happen. In some cases, though, as with a renovation loan, you might get away with a lower down payment.
By planning ahead and making sure your finances are in order, you have a better chance of qualifying for a construction loan.
Prepare for a Longer Closing Period
Realize that there are many moving parts to your home construction loan. It’s not just you and your lender involved. You’ve got a builder or contractor as part of the arrangement, and you’re not going to get a lump sum. Instead, the lender will evaluate you and the contractor you choose separately.
Additionally, a timeline for disbursements needs to be set up. Moreover, a lender might need to consider insurance related to the process. Plus, whether you choose a construction-to-permanent or construction-only loan matters a great deal as you negotiate with a lender about your terms.
As a result of these different aspects of construction loans, you might have to allow for a longer closing period. Additionally, you’re likely to see delays and additional costs during the building portion, so making sure you have adequate contingency reserves built into your new home is vital.
A construction loan can help you create your dream home, whether you build from scratch or convert a fixer-upper. However, you need to be prepared for the differences that come with it.
Your lender won’t simply approve you for an amount and give you the full sum without ensuring that you will use it responsibly. Instead, you’ll have to prove that you can handle the loan. They want to see that your construction project is viable. They will also watch you every step of the way as funds are doled out.
If you understand how a construction loan works, though, it can be a great tool for ensuring that you get exactly what you want in a new home.
See also: Is It Cheaper to Build or Buy a House?
Construction Loans FAQs
How do I qualify for a construction loan?
To qualify for a construction loan, you will typically need to have a good credit score and a sufficient amount of equity in your property (if you are building on land that you already own). You will also need to provide a detailed construction plan and budget, as well as proof of your ability to repay the loan.
How long does it take to get a construction loan?
The process of getting a construction loan can vary in length depending on the lender and the specifics of your situation. In general, it can take several weeks or even months to complete the application process and receive approval for a construction loan.
How much can I borrow with a construction loan?
The amount that you can borrow with a construction loan will depend on factors such as your credit score, the value of the property, and the amount of equity you have in the property. Typically, you can expect to be able to borrow up to 80% of the value of the property. However, this can vary depending on the lender.
Are construction loans more expensive than other types of loans?
Construction loans may have higher interest rates and fees than other types of loans, due to the higher risk involved for the lender. However, the overall cost of a construction loan will depend on a variety of factors, including the lender, the type of loan, and the terms of the loan.
Can I use a construction loan to remodel my existing home?
Yes, construction loans can also be used to finance the renovation or remodeling of an existing home. Borrowers are typically required to provide a detailed construction plan and budget, as well as proof of their ability to repay the loan.