What is a construction loan and who would need one?
Construction loans are temporary financing options for people who are looking to build a home, rather than purchase an existing property. It’s not possible to obtain a standard mortgage on a property that hasn’t been built yet, so construction lenders create financing options based on the projected future value of the home. This is often a better option than paying for all the building costs out of pocket and applying for a mortgage once the property is complete.
You will commonly pay a premium when it comes to construction loan rates due to the short-term nature of these products. Rates are most often variable and fluctuate based on a predetermined interest rate plus the prime rate.
There are different types of construction loans available, with varying terms and conditions. The most common type is a construction-to-permanent loan that is comprised of two main steps: a construction loan followed by the creation of a traditional mortgage upon the property’s completion. The home construction loan is set up so that funds are released at certain milestones, or draws, to pay for labor, materials, and other costs. Interest-only payments are made throughout the construction process, usually just on the amount that’s already been disbursed. Typically, the house construction loan is set up for 6 months to a year and becomes due at the end of that timeframe. At that point, the loan is either refinanced into a permanent mortgage or paid in full.
Stand-alone home construction loans are also available, though not as common. These loans don’t have a balloon payment at the end of their initial term, and revert to a fully amortized payment structure once construction is complete and no more funds are being disbursed. Principal and interest payments are made until the loan is paid off or refinanced. Since many construction lenders aren’t interested in long-term loan servicing, it’s less likely to come across this one-time close construction loan type of product.
The FHA (Federal Housing Administration) has created their own version of construction-to-permanent financing for new properties, as well as special rehabilitation loans for existing properties that require extensive repairs and renovations. FHA 203k construction loans are the most common rehab loan products.
What are the requirements for a construction loan? Getting your finances ready for the loan process
The process of being approved for a new build loan is very similar to being approved for any other type of mortgage loan. How long it takes to get approved for a new home construction loan doesn’t take much time if you are organized. It requires information about income, assets, and credit – all documented thoroughly during the process. First, make sure your tax returns are filed for the most recent 2 years. For many lenders, not having your tax documents filed is a non-starter, especially if you’re self-employed or own multiple properties.
As with any form of credit, the better your credit scores are the more favorable your terms will be. Before applying for a loan, maximize your credit scores by obtaining a free annual report from one of the credit bureaus and removing any errors that you find. Next, pay down debts if possible, so that your utilization percentage is at or below 30% of your available credit. While you’re in the process of building your home, don’t be tempted to take on new debts or increase existing debts, like credit card balances. You will need to qualify based on your debt-to-income ratio at the beginning of the process, and again when you convert the construction loan into a permanent mortgage. If you haven’t sold your previous home, you may have to qualify carrying loans on both properties.
Build up your available assets a much as possible because you will need the construction loan down payment, reserves, and deposit funds as part of the building process. Most home construction lenders will require a down payment of 20% of the total loan amount, with some requiring 25% or more. This ensures that you have a significant financial stake in the property and are therefore more likely to see things through to completion. Having cash reserves will allow you the freedom to make changes to your original plans without having to revise the loan amount or terms. If you’re buying the land on contract, you’ll be expected to make a deposit on that contract to get things started as well.
Finding the perfect piece of property is one of the first steps people think of when considering building their own home. Lot and land loans are available so it’s not necessary to own your land before starting the construction mortgage process. It is necessary to make sure that the land is under contract with sufficient time to complete the building process, or to have the ability to extend the deadline or cancel the contract if you can’t get construction financing.
Vacant land for sale can be found in many of the same ways you’d find existing properties. There are real estate agents who specialize in undeveloped land, and listing websites that provide property details and photos. Even sites like Zillow and RedFin will allow you to search for land only. If you’re purchasing from a private seller, you’ll need to have your land financing in place ahead of time. Commercial sellers may be able to offer you financing terms directly.
Choosing a builder or contractor
When you’re selecting a builder or contractor, remember that they will likely have to be approved by the lender. Sometimes lenders have a list of pre-approved builders that they will work with and some will allow you to select your own, pending final approval. They should be experienced in working with construction lenders, and willing and able to meet all of the expectations and requirements. This means putting together very detailed plans, materials lists, and budgets and updating them continually throughout the process. Their ability to stay on schedule and on budget will be very important to your bottom line, as any delays or overages could cost you both time and money. If you are considering building the home yourself or acting as your own contractor, then the lender may have additional terms or requirements for you to meet.
Determine a comprehensive construction budget and timeline
Working with your builder, you’ll need to calculate timelines for draws or disbursements of funds to pay for materials, labor, and other costs. Having an accurate timeline will ensure that funds are available precisely when they’re needed, instead of causing a delay or creating unnecessary interest payments. The homebuilder will also need to provide your lender with detailed specifications, commonly referred to as a “blue book”. Here, they will detail construction practices, the type and quantity of building materials to be used, as well as the
Complete the loan process
Once the construction is completed, and your new home is ready for you to move in, the new construction loan has fulfilled its purpose and it’s time to transition that debt into a permanent mortgage. If you took out a construction-to-permanent loan, then there may already be terms in place and available for you make the switch. If not, you’ll need to go through the process of refinancing the loan before it’s due in full. Now that the property is complete, you’ll be able to go through the traditional loan process – having an appraisal done, completing title and escrow work, receiving a tax assessment, and recording the new deed and mortgage with the county.