Construction Loans: Everything You Should Know
Can't find that perfect home? Or, did you find it, but were outbid or lost it to another buyer? The housing market has been incredibly tough over the last year, and there aren’t many signs that it’s going to ease up any time soon. Have you ever considered building instead?
A lot goes into building a house, and financing is a huge part of it. Learning more about how construction loans work and discovering which is the right loan type for you can help you decide if building a new home is the right decision. Keep reading to learn everything you need to know about what is needed for a construction loan, so you can build or renovate the home of your dreams.
What is a Construction Loan?
A construction loan is a specific type of short-term financing designed to help borrowers build the perfect home, one that completely suits their needs and family. Construction loans are considered short term because they only cover the time period that a home is being built or renovated. This type of financing is quite different from a regular mortgage.
It’s important to understand those differences - like what the loan can cover, what interest you can expect and how long the loan lasts. Construction loans are typically one year-terms, during which time the borrower must finish the build and be able to produce a certificate of occupancy.
How Do Construction Loans Work?
While both a home mortgage and a construction loan are used for acquiring a residence, they vary in some important ways. A home mortgage is a long term loan that most often spans anywhere from 15 - 30 years. During that time, you make payments on the home and eventually pay it off over time.
A construction loan, by contrast, is much shorter in duration (again, usually under a year). The purpose of a construction loan is for you to build or renovate an entire residence. Construction loans must be paid off once the home is built. For most homeowners, this means getting a true home mortgage loan once the home is complete or nearing completion.
Types of Construction Loans
Still wondering: what is a construction loan and how does it work? There are several types of construction loans, and one may suit your needs much better than the others. It’s critical that you understand the differences between them.
What is a construction perm loan? This type of loan begins as a construction loan, and then once the home is complete, it simply merges seamlessly into a home mortgage. They are convenient and can potentially help borrowers save on fees, since financial closings only happen once, instead of twice. Also sometimes called a single-close loan (for obvious reasons), you’ll have some options if you go this route. For example:
- Once the loan converts to a traditional mortgage, you'll need to decide if you want a 15 or 30 year mortgage.
- Do you want an adjustable rate or fixed rate mortgage?
- And finally, will you use FHA or (if you’re eligible) VA loan financing?
Construction-only loans cover just the actual building of the home - not the eventual mortgage you’ll need to secure. These are short term loans, and you’ll have to refinance at the end of the term, usually into a mortgage product. While construction-only loans will cover the costs of building, this option may actually end up being a bit more expensive overall (especially when compared to a construction to perm loan). You'll essentially be taking on two different loans, and each will have their own closing costs and fees, etc.
Renovation loans may be a great option if your home exists, but is in poor shape or needs some new upgrades. A renovation loan can cover those costs of updating and upgrading an existing home. This financing type is often used when a physical property or land is desirable, but the actual dwelling or structure on it is not. Renovation loans can also be useful in areas where you’re not allowed to tear down existing structures. You might be permitted to update and alter them instead.
Owner-builder construction loans allow homeowners to also act as the builder. But be forewarned, unless you’re a licensed contractor with a lot of experience, this may be a challenging loan to get and use. Banks consider DIY builders to be high risk. You may have difficulty getting approved, and you’ll almost certainly have a substantially higher rate.
An end loan is the mortgage a homeowner applies for after the home building process is complete. It’s used after a construction only loan, and it allows you to complete the home buying process. Note that not all lenders have construction to perm loans as an option, so you may be forced to get a separate, new loan at the end of your build. Be sure you totally understand the ins and outs of your construction loan, so you know what the next steps are once your home is complete.
Example of a Construction Loan
You've found the perfect land, and now it’s time to build. You've been approved for a $500,000 construction loan. The first month, there are $75,000 in costs, so you draw on your loan to cover them. The second month has $25,000 in costs, so once again, you draw from the loan to pay for them.
The reason you pay for your construction loan in parcels is that you only pay interest on the part you’re using. Draws don’t have to happen monthly - rather, they generally occur per milestone. Foundation laid? You’ll pull from the loan. Framing starting? You’ll draw again.
Keep in mind, interest is only paid on the amount you have drawn, not the total amount you were approved for. And you don’t have to use the entire amount you were approved for.
Construction Loan Considerations
As with any loan, it’s imperative that you understand how your construction loan works and what borrowing will truly cost you.
Most first-time home builders will have a lot of questions, like:
- What is the interest rate on a construction loan?
- What credit score is needed for a construction loan?
- What is Blue Book on the home? (Blue Book includes all the specs of the home to be built, and it’s used in part to determine how much of a loan will be offered. You’ll need to have floor plans, know ceiling heights and have picked out some materials that you plan to use).
You'll want to research all of these questions to be sure building really is the right approach for you. Rates vary depending on a variety of factors, including your credit score, how much you’re borrowing, what your debt-to-income (DTI) ratio is, and more. Ultimately, interest rates will vary for each buyer.
Finally, be prepared to come in with a fairly healthy down payment. Traditional mortgages use the actual property as collateral - you default on the loan, and the lender takes your home. So some lenders will accept a much smaller down payment. Obviously, a half-built home is worth less to a bank, so construction loans are more risky to any lender, and will often require a down payment of typically between 20 - 25 percent.
Where to Get a Construction Loan
After you've decided on a loan type, it's time to determine what is needed for a construction loan. Construction loans are often offered by local banks and credit unions. Your local lender will likely have information on hand for you to review. To simplify the process, you’ll need to:
- Have a licensed builder
- Have all your documents in order - projet plans, detailed pricing, references for your builder and proof of their credentials
- Start the preapproval process
Building a home is an exciting time in your life. But it can also be a bit stressful, too. Knowing what to expect, and understanding the process can help you alleviate stress and feel more in control throughout the process. Construction loans offer homeowners and real estate investors another option when it comes to obtaining a new property. With a construction loan, you can design and build exactly what you want.
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