Construction Loans – What You Need to Know
Are you considering getting a home construction loan? Do you want to know how a construction loan works? Construction loans are a popular option when you own a piece of land and want to build a custom home.
When building your own house, chances are you will need to get a construction loan. If you have ever gotten a mortgage before, you have familiarity with how complex the loan application process can be.
If anything, the process of getting a construction loan is even more complicated. Plenty of people are approved for construction loans, though, so it’s certainly something you can succeed at if you are prepared.
Often, those taking out a construction loan have previously purchased land, probably intending to build their own homes. They either used a land loan or purchased the property outright.
As a real estate agent who has gone through two real estate recessions, another situation where construction loans become common is when it is a severe buyer’s market.
In times such as these, a builder may not be able to procure financing to build a home readily. Quite often, they will ask the potential buyer to take out the construction loan instead.
I have built two homes from scratch, both by taking out my own construction loan.
The following information will give you a basic understanding of how construction loans work. You can use this knowledge to start down the path to getting your own construction loan if it makes sense for you.
Let’s take a look at everything you’ll need to know about home construction loans. There several types of loans you may want to consider.
1. Construction Loans Are Short-term With Higher Interest Than Standard Mortgages.
A construction loan is designed to provide funding for the building of a residential property. The goal is to deliver the right amount of money a builder needs to complete the project when that money is required. Once construction is complete, the loan must be paid in full.
These loans are only offered over a short term – as long as it takes to complete the project – and they charge a higher interest rate than a conventional mortgage because there is more risk involved for the lender.
With a traditional mortgage, they use your home as collateral. They can take the house back and sell it if you default on the loan. If you default on a construction loan, there may be no property to seize if the project is not completed. A construction mortgage is considered a short-term loan.
You will often need a down payment of at least twenty percent when getting a construction loan. You will only have a higher rate for the period of construction as it will turn into a permanent loan when you’re done building.
2. Construction Loans Are Paid Out in Stages.
One of the things many people fail to realize about how construction loans work is that they are financed in stages. When the loan is approved, you get a single lump sum from the lender with personal loans. But with a construction loan, the lender pays you in stages as construction advances.
One of the things that makes these loans more complicated is the requirement to map out the building costs ahead of time and estimate how much money will be needed and when for each stage.
Typically, the lender will dictate the schedule in which they release the money. You will know how this schedule is set up ahead of time.
For example, the bank or lender may release funds when the foundation is installed and backfilled. This would be considered the first release or first draw of funds.
The second release may come when the home is completely framed, for example. You would then get a second draw from the lender.
These draws will come at a prominent construction phase until the project is completed.
How Does a Construction Loan Work (Video)
See a quick video explanation about construction loans and how they work.
3. You Usually Only Have to Pay Interest For Each Stage.
The staggering of payments on construction loans usually means you only need to pay interest on the money delivered thus far. You will have to plan to pay the loan at the end of construction in full, but until construction is completed, you will only need to worry about the interest due at the stage you are currently at.
One of the nice perks of a construction loan is that you are not getting creamed with high-interest costs until the very end, nearing completion of the project.
4. You Will Need to Have Detailed Plans For The Construction Project Before Getting The Loan.
When getting a construction loan, you can’t just provide your financial details like you can with a mortgage.
You need quite a bit more to qualify, including a builder’s contract that lays out the draw schedule for the funds, detailed plans on the project, and a construction timetable.
You will not be able to get away with just a floor plan but a detailed set of construction plans.
The budget has to be realistic for the type of property you are building. Getting all of this information requires working with a builder to produce the necessary documentation. Expect to spend time gathering everything you need to qualify.
Before committing to build a custom home, you should always ask the builder a ton of questions beforehand. Many of the things to ask will be centered around the builder’s qualifications and reputation.
It is vital to thoroughly interview a builder before choosing one. It is highly recommended to get cost estimates from at least three builders before ultimately selecting one.
5. The Lender Will Check on Your Project Periodically.
Lenders face higher risk with a construction loan, so they tend to be more careful about overseeing their investment. You can expect a lender representative to show up at your worksite periodically, especially when a new round of funding is supposed to be delivered.
Not that the representative is an inspector for the quality of the work but ensures the stage of construction is complete before they release the next round of funds to you.
When people ask, “how do construction loans work,” this is a key point to go over with them.
6. The Loan Will Only Pay For Construction Costs.
If you get a construction loan, you can only use that loan to pay for construction-related costs like materials, labor, and permits. You can’t use the loan to pay for furnishings or other items that can be removed from the property.
7. What Documents You’ll Need to Provide The Lender For a Construction Loan.
Just like when you procure financing for purchasing a traditional loan, there are several documents you’ll need to provide the lender to get a mortgage. The resource covers the financial information you’ll need to disclose, but the lending institution will also require the following as well:
- A building contract between yourself and the builder or contractor (if applicable).
- Copy of the builders/contractor’s license.
- A set of blueprints of the house you are building.
- Detailed specifications on how the home is being built – things like the type of heating, plumbing, electrical, kitchen, baths, etc.
- Any quotes outside the building contract, such as swimming pools, sheds, landscaping, etc.
- If you are purchasing land as part of the construction loan, the lender will require a land survey. You might have an acre of land or 5 acres. The lender will want to know exactly what they are lending on.
- A breakdown of the cost of construction.
It should be noted that as part of the process of approving your construction loan request, the lender will do a home appraisal to make sure of the market value. Like any other mortgage, the lender wants to make sure they are lending on the appropriate amount.
8. The Builder Will Also Want a Deposit
An essential point for consideration when building a custom home is that the builder will probably want an upfront deposit of ten percent. Unlike a re-sale home where the earnest money is held in a third parties account, the builder will want to use the funds.
In tougher economic times, it is not unusual to ask the builder for a second mortgage against the deposit as a means of protection from loss of funds. It would be advisable to speak with an attorney to get this set up correctly.
Different Types of Construction Loans
There are a few different types of construction loans. Let’s take a look at each of the types of loans you may encounter:
1. Construction to Permanent Loan
If you plan on building a home and then moving into that home, a construction to permanent loan is probably what you will choose.
It combines a home building loan with a mortgage in one single package. You start with a construction loan to fund the building of the home and end with a mortgage after you have moved in.
The biggest reason to go with a construction to permanent loan is to minimize the fees you pay for your loan.
You will only pay closing costs once on this type of loan. If you were to get a construction loan and then go to get a mortgage, you would pay fees twice.
The construction to permanent loan is the best option to avoid having separate loans. This type of construction loan is the most common.
Just like when purchasing a re-sale home, you’ll want to vet the lender before choosing someone. In this circumstance, you’ll want to be selecting a financial institution that specializes in construction lending.
2. Construction-only Loan
Not everyone needs or wants a mortgage. Even if they want a mortgage, they may decide that they have a reason to get a construction loan from one lender and a mortgage from another.
There is the construction-only loan for those who just want a loan for the construction of their home. This is also referred to as a stand-alone construction loan.
It’s important to note that these loans must be paid in full when the project is complete. Whether you use cash or get a mortgage, you will need to pay the loan off when your home is fully built. Usually, these types of loans are not the best option.
Most of the time, there is not a good enough reason to get a new loan from another lender.
With a construction loan, you will be given an interest rate based on the prime rate with the addition of a margin. The rate can change during the term of the loan, depending on when the prime rate changes.
You will get the money in stages based on the progress of your construction project. Each step you reach that was agreed upon during the loan application will result in another round of funding.
It may seem tempting to get a construction loan now and worry about a mortgage later when the project is completed. You should be aware that going this route will usually be more costly. If you get a separate mortgage from the construction loan, you will have to pay the fees associated with the loan twice.
Another problem with waiting until you finish the build is that you could find that your mortgage options have diminished or disappeared altogether if your financial situation gets worse.
If you are in good financial shape right now, it’s a better idea to get a construction to permanent loan to ensure you have all the money you need.
3. Renovation Loans
Renovations are another type of construction that often requires obtaining a loan. They are sometimes referred to as renovation construction loans.
These are usually smaller loans than for new home building projects and can come in various forms. One individual may only need $10,000 to complete a renovation project, while another might need $50,000. The way a lender meets the needs of a borrower can vary depending on the size of the loan and the borrower’s financial situation.
There are a few common ways that homeowners get renovation loans, including home equity lines of credit (HELOC) and unsecured personal loans. Some may decide to use a credit card. Each of these has advantages and disadvantages.
One thing to remember about renovation loans is that there is far less oversight from the lender. In most cases, the homeowner is the one overseeing the renovation project. They will get the loan and then write the check to the contractor. The lender may not be involved at all.
If you are considering a renovation loan, make sure you do your due diligence to find a contractor you can trust. Look for contractors who have the right qualifications, are insurance, licenses, and so on. Ideally, find one that has plenty of recommendations you can verify personally.
You can find someone to do good work – it’s just important to be careful because whether they do things right or not, you are still going to have to pay the loan off.A renovation loan may be the perfect type of mortgage when you are making an improvement to your property.Click To Tweet
4. Owner-Builder Construction Loans
An owner-builder loan is a construction-only loan for borrowers who are also building the property themselves. Not just anyone can qualify for owner-builder loans. In fact, you will probably only be able to get a loan like this if you are a licensed builder with plenty of experience.
Many lending institutions are leery of an owner-builder construction loan because they find it risky to trust anyone who isn’t a licensed general contractor with an established reputation for quality.
There are so many things involved in building a home – so many things can go wrong – that it is just too big of a risk for a lender to loan money to an unlicensed or inexperienced home builder.
An owner-builder loan is not uncommon when a larger developer is building subdivision houses.
5. End Loans
You may have heard about the term-end loan. An end loan is the same thing as a mortgage; it’s just another way of referring to a loan taken out at the end of a construction project.
There are numerous types of permanent loans to choose from with different amortization schedules. Picking the length of your mortgage should be something you do ahead of time.
Lenders today are much more flexible than they used to be in years past. For example, you might want to have your loan amortized over a certain period of time that is different from the traditional fifteen or thirty-year mortgage period.
Loan terms can be chosen just like you would with a conventional mortgage. You will want to speak to the financial institution you’re working with upfront on your desired loan term.
Who Does Construction Loans?
You may be wondering who are the major lenders that provide construction loan financing?
Some of the national banks that do construction mortgages are:
- Wells Fargo
- US Bank
- Prime Lending
- Northpointe Bank
- TD Bank
- First National Bank
While these lenders are some of the more recognized in the industry, you might be better off with a local lender. You may find there is an excellent local credit union that provides home building financing.
Credit unions sometimes can offer more flexibility than larger national lenders can.
When getting a new house loan, you should always check around with local builders and real estate agents to see who is doing them. You might find a better deal than one of the larger institutions.
How Much Do You Qualify to Mortgage?
Do you know how much of a construction mortgage you will be able to qualify for? Speaking to a building loan specialist will be essential. However, you can use this construction loan calculator to get a basic idea of how much of a mortgage you can carry.
Use the calculator to quickly figure out what type of loan you may qualify for and what the anticipated monthly payments will be on an initial interest-only loan.
The loan calculator also lets you calculate the conversion of the loan from construction to a traditional conforming mortgage, which amortizes as well as determines the monthly principal and interest payments on that portion of the mortgage.
It is vital to note that lenders will be looking for all borrowers to have good credit and an income ratio that makes them comfortable to lend the money.
Plan For Additional Costs/Expenses
From experience, one of the best tips I can give you about getting a construction loan to build your dream home is there will undoubtedly be cost overruns. Without a doubt, you will see things you really want that will cost more money than you thought.
Many of the finishes you choose will not happen to the end, such as flooring and appliances. It is so easy to get carried away by seeing the latest and greatest refrigerator that you just have to have.
The problem with that is it costs two-thousand dollars more than the one you budgeted for. Now think about this happening quite a few times, and it is easy to understand why people spend more than they plan to.
There are other times when the cost overruns can happen right upfront. For example, the cost of developing land is often more expensive than initially anticipated. You might run into ledge on the property that needs to be blasted – something that can be very expensive, depending on the scope.
If the lot is served by a septic system and not a public sewer, this is another area where there could be unplanned expenses. The same thing goes if the property is serviced by a well that can be expensive to drill. There will always be miscellaneous costs when building a home.
FAQs About Construction Loans
1. Is it hard to get a construction loan?
It is more difficult to get construction loans than traditional financing. It is harder to get a construction loan because the lender is taking on additional risks. Before and during construction, the bank does not have a tangible asset.
You will need to have a great credit score.
2. Are interest rates on construction loans higher than regular mortgages?
Yes. The interest rate of construction loans tends to be higher than the going interest rate for a regular home mortgage. It is not unusual to pay an interest rate that is one percent higher.
3. What will a new home loan cover?
Construction loans can cover numerous expenses, including purchasing the land, building permits, building materials, permanent fixtures, construction labor, paying the builder, and more.
Once the project is complete, you will then have permanent financing.
4. Can construction loans include land?
Yes, with a building loan, your total mortgage can include the cost of the land along with the cost to build the property.
5. Can you get an FHA construction loan?
Yes. FHA offers a construction loan. Just like a traditional FHA loan, you will be able to put 3.5 percent down. The Federal Housing Administration backs these kinds of construction loans.
6. Can construction loan interest be deducted from your taxes?
Yes. You are allowed to deduct the interest on your construction loan as long as it is secured by the home you move into. A home under construction can qualify for up to 24 months, but only if it ends up being your qualified home at the time of occupancy.
7. Can a construction loan have a fixed rate?
Yes. A construction loan will convert into a permanent mortgage after construction is completed. Like any other mortgage, you will have the option of choosing the length of the loan and whether you want the interest rate to be fixed or adjustable.
8. When is a new home loan needed?
If you own a piece of land and would like to have a builder construct the home, they may require you to take out the building loan. Some builders prefer to have the owner of the land finance the project. The builder gets paid on a contract basis with typically a percentage of the cost to build as their profit.
9. Can you get a building loan for a modular home?
Yes, you can get a construction loan for modular housing. You might even be able to get construction loan financing for a shipping container home as well, although it will be more challenging. Fewer lenders are granting mortgages for shipping container housing. As they grow in popularity, that could change.
9. When are you able to move into the house when you have a construction loan?
With construction loan financing, you can typically not move into a home until the city or town has granted an occupancy permit.
Final Thoughts on Construction Loans
Hopefully, you now have a better understanding of how a new home loan works. Getting construction financing isn’t rocket science, but it does require a little more planning than a traditional mortgage. Hopefully, the tips provided on procuring building loan financing have been helpful.
You should have a much better understanding of the process of getting this type of mortgage. Ensure you have a qualified builder and keep in the back of your head there will probably be unexpected costs you didn’t plan for.
More Exceptional Mortgage Resources
Get more valuable mortgage advice in these articles from Maximum Real Estate Exposure.
- Who can give a down payment gift – did you know when purchasing a home, a lender will let you receive down payment gift money from various sources? In the article, you will see a complete overview of what you need to know about down payment gifts.
- Questions a lender will ask – when you are applying to get mortgage financing, there are things a lender will ask that you should be prepared to answer. See what you need to know.
About the author: The above Real Estate information about how construction loans work was provided by Bill Gassett, a Nationally recognized leader in his field. Bill can be reached via email at firstname.lastname@example.org or by phone at 508-625-0191. Bill has helped people move in and out of many Metrowest towns for the last 34+ years.
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