How construction loans can finance your dream house
A mortgage may be required to purchase your dream home. But building your dream house? A mortgage with a twist is required construction loans to build your dream house. Namely, a construction loan.
What is a Construction Loan?
Construction loans are mortgages with a shorter repayment term and higher interest rates that can be used to pay for the construction or rehabilitation of a house. As construction milestones are reached, the lender pays the contractor a construction loan. Home construction loans can be converted into permanent mortgages, or fully paid once the building is completed.
The building process is your chance for everything you desire in a home. However, the loan process can be confusing. Before you start digging, learn how each type works and how to select a lender.
Construction loan types
Construction-to-permanent loans convert to a permanent mortgage when building is complete. Interest rates for single-close construction loans are also known as “single close” construction loans. They are locked in at closing. These loans work best for those who have a clear construction plan and are looking for predictable interest rates.
Construction-only loans (also known as “two-close” loans in construction) must be repaid once the building has been completed. These loans require that the borrower be approved, qualify and pay multiple closing costs. If you do not have sufficient cash or are looking for a permanent lender to finance the construction phase, construction-only loans may be an option.
Renovation construction loans allow you to finance major renovations through the mortgage, instead of financing them after the closing. The home’s current value after renovations and repairs is the basis of the loan. If you’re looking to buy a fixer-upper, but don’t have the cash to renovate it, these loans are a good option.
What is a construction loan?
Each project is unique, but loans generally pay for:
- Plans, permits, and fees
- Material and labor
- Closing costs
- Reserves for contingencies in case of higher than expected costs
- If you do not want to pay interest during construction, keep an interest reserve.
What is the process of construction loans?
Construction loan for new construction
You can’t borrow money to build your house. There is no collateral. Lenders are nervous about this, so they will require you to go through additional steps before they approve the loan. You should expect a thorough review of your finances and the plans by your builder.
“Examine the plans and builder of your home, as well your finances.
A construction loan can also be disbursed differently than a traditional loan. Instead of paying a lump sum to the builder, lenders pay them in monthly installments called “draws”. Each draw corresponds to an important phase of a project such as framing, foundation and finishing work.
A draw must be inspected before it is released to the builder. The amount of the payment is determined based on the completed work, as indicated in the inspection report.
Home remodel loans
A renovation construction loan is a great option if your dream home needs some TLC.
Fannie Mae’s HomeStyle Renovation Mortgage and Freddie Mac’s CHOICERenovation loan are common renovation loan programs. Also, FHA’s 203k loan, USDA’s Single-Family Housing Guaranteed Loan Program, and Freddie Mac’s CHOICERenovation loan are all examples of common loan programs.
The amount you can borrow to renovate your home is similar to a traditional construction loan. It all depends on the value of the property once repairs and upgrades have been completed. Your contractor and your renovation plans must be approved by the lender. The lender will still pay the money in monthly installments.
A construction loan is a better option than a personal loan or home equity line credit. You’ll pay a lower interest rate, and you will have a longer repayment term.
Get ready for the builder review
Mortgages are usually between a lender or borrower. Construction add another party to the mix: the contractor. Your contractor’s ability and willingness to finish the construction plan on time and within budget is crucial. So make sure you hire wisely.
“Look at previous work and check the references of the builder. Faries advises that you ensure their plans and specifications have been approved by your local building authority before they can move forward with the project.
A lender might request the builder’s history, proof of insurance, blueprints, specifications and a detailed budget. They may also require a signed contract detailing start and end dates.
What is the minimum down payment required for a construction loan.
For new construction, a 20%-30% down payment is required. However, some loan programs for renovations may allow for a lower down payment. FHA 203(k), for example, allows down payments of as low as 3.5%
How to obtain a construction loan
Lenders will differ on the minimum credit score, maximum debt to income ratio, and down payment requirements for loans. These requirements will vary depending on how much money you borrow.
Lenders will examine your:
- The ratio of debt to income: Lenders expect that your debts should not exceed 45% of your gross income. Lower is better.
- Credit score Most lenders of loans require a credit score of 680 and higher.
- Down Payment: Typically, a 20%-30% down payment is required for new construction. However, some loan programs allow for a lower amount.
- Repayment Plan: If you have a construction-only loan the lender may want to know whether you will pay the remaining balance in cash or refinance after the building is completed.
How to select a lender for a construction loan
Ray Rodriguez, TD Bank’s New York regional mortgage sales manager, said that not all mortgage lenders offer a construction product. Compare the rates and terms of different lenders once you have found a few that offer construction loans. He recommends that you get prequalified before you even consider blueprints.
Rodriguez advises that you get prequalified before you even consider blueprints.
Rodriguez says that credit underwriting for construction loans is the same as traditional mortgages, but it may take longer to close due to multiple parties and subjective underwriting based on future values.
It takes time to build a home. There are many moving parts. You need to choose your financing carefully.