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Using a Construction Loan To Build a House

tl;dr

What You Need To Know

  • Construction loans front you cash to build a new home (or even renovate a home)
  • Some construction loans convert to regular mortgages once the property is built
  • Down payments and interest rates are usually higher than they are for conventional mortgages

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House hunting can be both exhilarating and exhausting – you’re all swept up looking at other people’s interpretation of a dream home. 

While there might be that one property that could tick all your boxes, it’s not a guarantee. So, what if you had the opportunity to build your own dream house? 

A construction loan will get you the funds you’ll need to build your tailored-to-you dream home or renovate your current digs. 

What Is a Construction Loan?

Construction loans are short-term loans that help you cover the costs of building a new home. These loans usually carry a higher interest rate than a long-term mortgage loan, and that’s because the lender has more risk to carry. 

The construction loan pays out in installments, and these installments are known as “draws.” There is a draw each time the builders reach different construction milestones. The inspector checks the progress and okays the payments. 

Each construction loan financing option is different, but you can usually expect to make your first interest-only payment on the loan 6 – 24 months after the lender makes the first draw (or payment) to the builder. 

What Does a Construction Loan Cover?

A construction loan is designed to cover the costs of building a home from the ground up. It covers every aspect of the build, so the home is ready to receive you and all your furniture on the day you get the certificate of completion. 

Typical expenses covered by a construction loan include costs directly associated with the build. These include the land purchase, closing costs, labor and building materials, as well as the less obvious ones, like plans, permits and inspection fees. 

On top of construction costs, you can use your loan to pay for permanent fixtures, which might include kitchen appliances, sinks, bathtubs or showers, and even landscaping materials, like fencing or grass. 

Furniture and decor are considered non-permanent and are generally not covered by construction loans.

Another area that can be covered by a construction loan is the interest reserve. It allows your lender to advance the funds to cover interest charges on your outstanding balance. 

If home renovation TV shows have taught us anything, it’s that construction is not without risks or surprises. Turns out those surprises aren’t just for our entertainment.

The surprises can include stuff like overlooked repairs, an extra inspection fee, material changes because of shortages and any changes to the plumbing, electrical or other systems in your home.

The good news is that you can keep some of the loan set aside for contingency reserves, which are only used to cover the unexpected expenses that often come up when you’re building a new house. 

Construction loans can also be used for home restoration and renovation projects. If you’re in the market for a fixer-upper or you simply want to improve the home you live in, talk to your construction loan lender about the possibility of getting financing.

How a Construction Loan Works

It’s important to know what you’re signing up for when you take out a construction loan. Typically, construction loan interest rates are variable, meaning they move up or down along with the prime rate

Because the lender doesn’t have a property that automatically acts as security (aka collateral) – which is the case with mortgages on existing homes – the risk to the lender is higher. So, you can expect the interest to be a bit higher than they are with traditional mortgage loans. 

Apart from your personal financial standing, your lender will also need to know all the nitty-gritty details of your construction project. That includes your construction schedule, plans and budget. 

Once your loan is approved, your lender will advance payments that match your building schedule, doling out cash only when necessary. During construction, you’re usually only on the hook for interest payments.

Your lender might want the loan repaid in full once construction wraps up. Depending on the loan type, you might have to convert your construction loan to a long-term mortgage at the end of the project (if this doesn’t happen automatically). 

Any special considerations for construction loans?

A construction loan has a very specific set of rules. They include the full disclosure of all of the necessary building documents, like building plans, contractor invoices, permits and expected milestones. 

The budget is also important. And while the loan assists with some of the costs to get your project started, the borrower is expected to make a down payment of at least 20% – 25% of the loan amount. 

Lenders typically have a roster of builders they work with. If you choose a builder the lender doesn’t work with, the lender may need to see some additional information. 

This includes checking that the builder’s licensing and qualifications are in place and that they have a good professional reputation. The background check is important because it affects the integrity of the build. And it will give the lender some peace of mind that the project will be completed on time. 

Types of Construction Loans

Your dream home could be built with one of these construction loans:

Loan TypeWhat It IsWhat It Entails
Construction-to-Permanent LoansA loan that covers new home construction and converts to a permanent mortgage.It’s a single application process with one closing cost for construction and mortgage financing.
Construction-Only LoansA short-term, variable-rate loan for new home construction that’s repaid in full once construction is completed or the loan is refinanced.The borrower needs guaranteed incoming cash to pay off the loan balance at the end of the construction loan term. The cash can come from the sale of a previous home or another source. Alternatively, they can complete two mortgage applications (and attend two closings) to finance the loan balance.
Renovation LoansA loan that’s designed for fixer-uppers – it covers the purchase price and renovations.Renovation plans should be developed before applying for the loan because the loan amount is based on the anticipated appraised value. 
Owner-Builder Construction LoansThis loan is intended for homeowners who are acting as their own general contractors.Homeowners usually need to prove their experience as home flippers or home builders to qualify.
End LoansA mortgage that’s issued after the property is built.Not all construction loans convert automatically, so an end loan sometimes requires a new application.

How To Get a Construction Loan

In most cases, getting a construction loan is similar to getting a traditional mortgage. Your lender considers the same factors when deciding whether to give you a construction loan: your job, your income and your credit history. 

The one hiccup is collateral. Since you don’t have a home to put up as collateral, there are a few extra hoops you’re going to have to jump through if you want to get a loan to build your new house.

What are the qualifications for getting a construction loan?

Before you head to the bank or credit union to apply for your loan, you need to make sure your finances are in order. Figure out your debt-to-income (DTI) ratio, and make sure you can afford the house you’re planning to build. 

Most loan officers want to see no more than 43% – 45% of your income going toward paying for the construction. 

Make sure you have a repayment plan in mind, too. That’ll be especially important if you opt for a construction-only loan instead of a construction-to-permanent loan.

Besides your DTI, there are a few other things your lender is going to look into before they hand over any cash.

What down payment is required for a construction loan?

Your lender will need to know that you can make your down payment. The amount required will vary, depending on several factors, including your credit history and the type of construction loan you apply for.

When you apply for a construction-to-permanent or construction-only loan for a new build, most lenders want a minimum of 20% down. A renovation loan typically works more like a mortgage and has a lower down payment. In most cases, it’s about 6%.

What is the minimum credit score for a construction loan?

Most lenders look for a credit score of 620 or higher to approve a construction loan.

Got It? Here Are the Steps To Get a Construction Loan

It all starts with a dream. Design your home (or pay someone to do it for you) and find a builder to take on your project. Once you’ve got a plan and a builder, it’s time to get your papers in order. You’ll want to have:

  • Blueprints 
  • A contract with a registered, licensed, approved builder
  • A construction schedule
  • A detailed budget

Next, contact a lender to get preapproved. Preapproval tells you how much you’re qualified to borrow based on your credit score. Make sure the estimated loan amount works for your budget. If it does, you are one step closer to building your new home and picking a lender to work with.

How To Find a Construction Loan Lender

Choosing the right lender can make a world of difference in your construction loan experience. You’ll want to do some comparison shopping to find the right lender. 

When it comes to lenders, keep an eye out for great interest rates, a solid professional reputation and excellent after-sales service. 

You’ll want to spend some quality time on the browser of your choice reading online reviews and comparing the following: 

  • Application procedures
  • Interest rates 
  • Terms
  • Down payments
  • Conversion options once construction is completed

It can also help to look at flexible financing options, like Federal Housing Administration (FHA) construction loans. If you’re a service member, you should check out Department of Veterans Affairs (VA) construction loans

In some cases, these options may have looser underwriting guidelines and lower interest rates, making them a bit easier to get and more affordable.

Factors To Consider About Construction Loans

While you’re looking at construction loans, make sure to take an objective look at your plans and consider any potential roadblocks that might slow your project schedule or ability to repay the loan.

It’s not uncommon for unexpected issues to come up during the construction process, like material shortages, contractor delays and environmental problems. A well-designed schedule that budgets in some room for the unexpected is important if you want your loan draws to come through on time.

You’ll also need homeowners insurance – even during the construction process. Your lender will require it to protect the house against vandalism, theft and environmental damage.

If you know you won’t be able to pay off the loan when construction is done, consider a construction-to-permanent loan that automatically converts to a mortgage and saves you from having to pay closing costs for another loan.

Building a Dream Home Takes Time

Before you apply for a construction loan, it’s important to have everything in order. Find your builder, prepare your documents and get your finances in order before you apply for a loan. It will help the process go much more smoothly.

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In Case You Missed It

Take-aways

  1. Construction loans can fund new-construction homes and fixer-upper projects, but their loan terms will vary
  2. Construction loan financing is harder to qualify for than traditional mortgage loans or conventional mortgage loans
  3. You need to have your building plans ready and a builder hired before you apply

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