How Construction Loans Work
When you buy a home, you can usually rely on a standard mortgage to pay for it. But when you build your home from the ground up, a regular mortgage may not suffice. Instead, you might need a construction loan.
In this installment from our Guide to Building Your Own Home, we'll cover everything you need to know about construction loans.
Read on to learn how home construction loans work, how they differ from conventional mortgages, what you need to qualify, and what happens once your home build is complete.
What is a construction loan?
A construction loan is short-term or temporary financing that funds your home build and is paid out through a series of installments as the construction advances.
Construction loans are considered riskier than standard home loans, since no house exists that the lender can secure as collateral. As such, you will typically need to make a down payment of at least 20%. This down payment is based on the combined cost of the land and estimated construction costs.
For instance, if the land you are buying costs $150,000 and your estimated homebuilding expenses are $250,000, your down payment must be at least 20% of $400,000, or $80,000.
Interest rates are also typically higher for a construction loan, usually by around 1%. But the specific rate will depend on the type of home you’re building, its location, loan terms, and more.
While your home is under construction, you will be charged only interest on the amount disbursed to your builder, according to Quicken Loans. And you will make interest-only payments until the home is completed.
Qualifications for a construction loan: What you need for approval
As with any other loan, you really need to have your finances in order. However, “given there is inherently more risk in financing a construction project, securing a construction loan is a more extensive process than obtaining a traditional mortgage," explains Steve Kaminski, head of residential lending at TD Bank.
For instance? "Some lenders may require marginally stronger credit scores or increased documentation to ensure those risks are mitigated.”
Plus, along with evaluating your credit score and overall financial situation, lenders will also closely examine your builder.
“The project plans, costs, and land value are some of the things taken into consideration by the lender's appraiser so that the value of the overall project is adequately compared to other homes recently sold,” he says.
As such, you will need to have all the details of the project in place before applying for a mortgage, and you’ll need to provide more documentation for a construction loan than you would for a standard mortgage, says Christian Wallace, head of sales at online mortgage lender Better.com.
Exactly what varies by state and lender, but usually loan applications require building permits, property surveys, building plans, signed construction contracts, proof of land purchase, project specifications, estimated costs, and a timeline for the build.
Lenders also determine real estate tax estimates for the completed project.
“Lenders will closely review the project plans to ensure the quoted costs are aligned with current market costs, and will also estimate a financial cushion for budget overrun, or in case the borrower makes any upgrades once construction is underway,” Kaminski explains.
How to get a construction loan
Not all lenders offer construction loans, so you should ask your team of building professionals you are working with for a recommendation of a lender with plenty of experience with construction loans.
“It's important to work with a lender with deep expertise in construction loans who can guide the borrower through the process,” Kaminski says. And, it’s a good idea to meet with a loan officer as early as possible in the process to understand what documentation you’ll be required to provide.
Another reason to find the right lender: They’ll help keep the project on track, he adds. Many lenders work closely with builders at the start and during construction to review and approve project plans at each stage to make sure it’s been completed. They also make payments directly to the builder in predefined installments.
“So it's common for borrowers to work with builders and lenders who have an established, good working relationship,” Kaminski says.
Types of construction loans
There are essentially two ways a lender will handle a construction loan:
Stand-alone construction loan: This loan covers just the home build, and you’ll have to apply and get approved for a separate mortgage to cover the home once it's fully built.
If you have a stand-alone construction loan, you’ll have to secure a traditional mortgage to pay off the construction debt once your home is completed.
“This requires a separate [second] closing," Kaminski says. "And the interest rate will be based on the rates at that time, and can therefore be less predictable.”
Construction-to-permanent loan: This is where the lender will convert the construction loan into a traditional mortgage after the home is built.
These loans allow borrowers to lock in their interest rates at the start of construction and not have to worry about rate fluctuations while the project progresses. There’s only one closing, so you’ll just have to pay closing costs once.
All in all, a construction-to-permanent loan is the more streamlined option, but not all lenders will offer this to all borrowers. Make sure to discuss both possibilities with your lender to figure out which one is right for you.
Construction loan exceptions
Not all new builds require construction loans. If you’re buying a home from a local builder who has already bought land and is building multiple homes within a community, your financing may be similar to the purchase of an existing home. But if you choose to build a custom home, you'll likely need a construction loan instead.
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