Construction Loans (Construction Loans Explained)

Building a home and need to finance it? You need a home construction loan. Scroll down to learn more about this loan.

Construction Loan - What is It?

These are loans that finance a land purchase and the eventual construction of a residential building on the said land. Some loan types may only finance the construction phase, and these are known as standalone construction loans. These are usually short-term loans. Another type, the construction-to-permanent loan, transitions into a mortgage when the construction work is completed. 

Home construction loans can be used for - 

• Purchasing the land.

• Purchasing the building materials.

• Paying the contractor for labor.

• Acquiring the required permits, and so on.

Construction Loan Term

A critical aspect of this loan type is that it is connected with the progress of the project. The term is usually a year or less. This means that you are expected to acquire the land and finish the construction within a year of getting the loan.

Lenders will ask for many details and need to be informed at each phase of the project. You will initially be required to submit detailed plans, construction timelines, and a budget. Remember, the lender releases the funds at different phases, and that too directly to the contractor.

Construction Loans Rates

Home construction loans have variable rates. You can expect fluctuations and spikes in the rates in accordance with the prime rates. This affects your monthly payments - at times, it could be high; at other times, it could be low, and so on. 

Construction loan interest rates are usually higher compared to traditional mortgages. In the case of the latter, your property works as a collateral. It means that in case of any outstanding from your end, the lender has the right to put it up for sale and recover their money.

This option does not exist with the lender in the case of a construction loan, so the interest rates are high.

In general, the difference between construction loan rates and traditional mortgage rates is 1%. Use a construction loan calculator to find the exact rate applicable to your case.

Types of Construction Loans 

• Construction-to-Permanent Loan

In this type, the loan gets converted to a traditional mortgage once the construction is complete and you shift into the house. The term of such loans is usually between 15 and 30 years. Borrowers can choose between fixed-rate mortgages and adjustable-rate mortgages.

You can take conventional home construction loans or choose an FHA construction-to-permanent loan. If you are a veteran, you can choose a VA construction loan. The biggest benefit of this loan type is that the closing costs must be paid once.

• Construction-only Loan

In this type of loan, funds are given to construct the home. The borrower is required to repay the complete loan amount once the term ends, which is usually a year or less. The repayment can be made in cash or through a mortgage. In the latter case, construction-only loans are expensive. 

• Renovation Loan

If an existing property must be upgraded, a renovation loan is the best option for you. If the amount required for the renovation is less, you can take a personal loan or even fund it with your credit card. A home equity loan is a good solution for renovations valued at $25,000 or more. Cash-out refinance is another option where a new mortgage can be taken, and the extra amount can be used to finance the renovation. In the case of this loan type, lenders usually do not require much detail about the proposed use of the funds.

• Owner-builder Construction Loan

These are other construction and construction-to-permanent loans where you act as the home builder. You will need expertise and experience in home construction to prove the same to the lender. Lenders usually offer this kind of home construction loans to licensed builders.

• End Loan

An end loan is a mortgage that the homeowner must pay off after the property’s construction is completed.

Getting a Construction Loan

• The first step in the process is to find a licensed builder. The best option is to use NABH’s directory of home builder associations in your locality. Remember, lenders will want to meet and know more about the builder before they lend the money. Before finalizing a builder, ensure that you conduct a comparative evaluation to understand the strengths and weaknesses and the track records of the builders.

• Once a builder is onboard, you need to find a lender. You can often approach credit unions or regional banks for a loan. You must compare the construction loan rates, loan terms, and the down payment before finalizing.

• Do the paperwork correctly. The most important paper is the builder contract. Other details required will be financial documents like tax and bank statements, pay stubs, assets, etc.

• Pre-approval of a loan is the next step because it will help you understand the amount that you can get as a loan. 

• Lastly, it would help if you bought a prepaid homeowners insurance policy. Your lender will require you to get the policy and ensure it covers the builder’s risk coverage.

Requirements to Get a Construction Loan

As a borrower, there are specific requirements that you need to match. These are - 

• Your debt-to-income ratio should be low to get a good deal from a lender. The minimum credit score required for such loans is 680. They will want proof that you have the earnings to repay the funds.

• Like most other mortgages, you must make a down payment, which is usually about 10% of the loan value.

• Your construction plan should be ready because lenders will give a lot of weightage to details in this case.

• Lastly, you need to get the property appraised, especially in the case of a construction-to-permanent loan or a construction-only loan. 

Remember to use a construction loan calculator or speak to an expert like Total Mortgage to get the best construction loans in the United States.