Construction Loans: What You Should Know
Building your own home can be a tremendously rewarding experience. You get to make choices about everything from location and floor plan to colors and landscaping. At the end of the process, you have a truly special place to live, something uniquely yours.
While a project like building your home can be both exciting and fun, there are many things to consider before you start building. Probably the most important consideration is how this type of project gets paid for. Stress over money and financing can ruin the entire home building experience.
Unless you have the cash on hand to fund your construction project, you are going to need a construction loan in order to finance the cost of the building project –and sometimes the purchase of the land itself.
A construction loan is a short term loan (12 to 18 months) that covers the cost of construction until the home is complete, and a traditional mortgage can be taken out.
However, it’s important to note that this type of funding isn’t the easiest to obtain; largely because this type of loan is considered far more risky than a traditional mortgage. New construction financing differs from resale finance because the home itself doesn’t exist. This means if the payments stop and the lender needs to foreclose, they must finish constructing the house first. Naturally, this makes construction loans riskier and lenders more wary.
Generally, construction loans are issued by a bank, rather than a mortgage lending company –and you’ll want to shop around at a few different banks to see what your options are and to find the best loan terms possible. Bear in mind that these loans will require at least a 20% down payment, but some lenders will require as much as 25% down. Also, the interest rates on these loans tend to be higher than traditional loans, so you’ll want to shop around to find the best option before you sign on the dotted line.
If you’re on the fence about building your own home –and curious about funding options, here’s a look at what you should know about new home construction loans.
Different Types of Loans for Different Types of Homes
First up, it’s important to note that there are two basic options available when it comes to a new construction financing. The first is custom home financing, which is where the buyer owns the land and the house. The second is going through a tract home builder –which is where the builder owns the home during the construction process.
Let’s take a look at both options now:
- Tract Home Builders
In very rare cases, the builder will be willing to carry the financing for the project. But this is usually only the case with large tract builders. With this option, you’d lose the flexibility that you’d have with a custom builder.
Here’s how it works:
Tract home builders handle the construction portion of their financing, and they own the home throughout the entire building process, and then at completion, they transfer the title to the buyer. This type of builder pays for the lot, and then builds the house to your specifications. When it’s done you close on a permanent 15 or 30-year mortgage.
Builders will often incentivize buyers to use their preferred lenders, as this gives them confidence that the buyer will be able to close. They may even give you credit towards closing costs or upgrades to use their preferred lender.
- Custom Home Financing
This type of financing differs from tract style or production home financing, in that the buyer generally owns the land and the house during the entire building process. With this option, the builder is essentially employed by the homeowner as a general contractor to build the house, so you’d have a lot more freedom in terms of how the house is built.
At closing, the buyer pays off the construction loan with a permanent 15 or 30-year mortgage.
Different Types of Construction Loans
Construction Loans are usually short-term higher interest loans that last until the home is completed.
In most cases, the lender pays the funds directly to the contractor, rather than the borrower. These payments –also known as draws, often come in installments at different stages of development –rather than all at once.
Now, let’s get more specific, and look at some of the different types of custom home financing that are available today.
- Construction Only Loan
Buyers who choose a construction only loan are usually looking for the best deal possible on the permanent loan.
With this loan, the lender will typically offer enough money to cover the cost of the project, and the borrower will usually make interest-only payments until it’s complete. The principal balance is commonly due in full once the project is complete, or one year later. This allows the borrower the freedom to apply for a mortgage with another lender once the project is complete. If the buyer chooses this route, make sure you know what to ask your lender before choosing a loan product.
- Construction-to-Permanent Loan
With a construction-to-permanent loan, the buyer takes out a loan from the lender that’s essentially a line of credit, and the builder can draw from it at each stage of construction. There are inspections at the project site to approve each draw.
At the end of the project, this loan can be rolled into a permanent loan, usually with the same lender, just like a buyer would on a resale property.
The construction-to-permanent mortgage loan usually covers the cost of the construction project and the mortgage on the completed property. An interest-only payment option may still be available with this type of loan, typically for one year. There is only one closing with this type of loan because the borrower will be working with the same lender for the construction and the mortgage. The interest rate is usually different for the duration of the construction and will change once the mortgage payments begin. There may be a penalty if construction exceeds one year.
- Single Close Loans
Single close loans are a newer loan product and are becoming very popular with homebuyers.
Normally, with a two-time closing loan, if anything were to happen to the borrower’s financial situation between the time construction starts and the time they are ready for the permanent loan, then they may have problems qualifying.
With the single close loan, though, once the borrower is approved they’re approved. The buyer closes one time. When construction is complete this loan becomes a permanent loan and the construction portion gets paid off from the permanent loan.
The single close loan eliminates additional fees as well as the hassles that are usually associated with administering a construction loan. This loan requires only one application and once it’s approved there is no secondary approval process required.
- VA and FHA Construction Loans
There are VA and FHA construction loans available as well. However, these loans can be difficult to qualify for, and may be hard to use because of loan limits. Learn more about these loan options.
At the end of construction, you’ll usually move into what’s known as permanent financing. At this point, you’ll also have to option to pay off the loan or convert it into a traditional home mortgage.
Qualifying for the Loan: What You’ll Need
In order to be approved for a construction loan, there are some terms and conditions that need to be met. Each lender will have different criteria that the borrower will need to meet, as a self-build loan is much riskier than traditional mortgages, the standards can be strict.
As always make sure you speak with a lender before you begin, to see what you’ll need to do to qualify.
Generally, though, they’ll want to see:
- Qualified Builder
First up, the lender will want to see that you’re working a qualified builder. This means a construction company or a licensed general contractor who has a solid reputation for building quality homes. If you’re planning on being your own general contractor, you may have a difficult time being approved for a home construction loan.
- Detailed Specifications
Next, it’s not enough to simply request a loan –you’ll need to provide the lender with detailed specifications on your plans. This is sometimes referred to as “the blue book.” This book should include everything from materials that will be used –like insulation and roofing, as well as the specifications on ceiling heights and room dimensions. These plans should be professionally drawn up and to scale.
- Value Estimated by an Appraiser
The value of the home must also be assessed by an appraiser. The appraiser will consider the specs in the blue book, and the value of the land it’s built on. These calculations will then be compared with other similar houses in similar locations.
- Proof of Income
Next, you’ll want to be ready to provide proof of income, so be prepared to provide bank statements or proof of income in the form of W2-s; or tax returns, if you’re self-employed.
- Down Payment
As we touched on earlier, typically, you’ll need to put down a large down payment of at least 20% for a new home construction loan. Some lenders will even ask for 25%. This is due to the level of risk associated with the loan, as there’s no collateral in place, since the house hasn’t been built yet.
- Good Credit Score
You’ll also need a good credit score. A score of at least 680 or 700 will generally be required.
- The Numbers Line Up
They’ll also want to make sure that the loan to value (LTV) isn’t more than 80%, including the value of the land. And the loan to cost will need to be less than 85% as well.
Things the Lender Will Need From the Builder
In addition to the criteria you’ll need to meet, here are some things the lender will need to see from the builder as well:
- Project description
- Building license
- Proof of Insurance
- Banking info, profit and loss statement
- Budget for project
- Signed contract with buyer
- Specs that support the terms of the contract
- Job cost
Do You Have a Plot of Land?
Finally, be sure you have a plan for the land that you’ll be building on as well. If you don’t already own the land, then you’ll need to include it in the construction loan. In most cases, it makes sense to pay for the land upfront if you can to save yourself from a much larger down payment.
If you’re thinking of building your own home, you’ll want to make sure you take the time to lay the groundwork first. Start by meeting with a qualified lender, to see your options, and find out what you’ll need to do to be approved. Then, make sure you find a qualified home builder, and work with them to create a detailed outline of your project. Finally, make sure you have enough saved up for a down payment, as you’ll need at least 20% down.