Construction Loans: What Are They? And How Do They Work?

Construction Loans: What Are They? And How Do They Work?

It can be an exciting opportunity to personalize your space by building a house from scratch. However, building a home can be costly just like buying one. Construction loans can help you buy the land and pay for the labor and materials that are required to build a new home.

However, construction loans come in many forms and approval processes are more complicated than traditional mortgages. We will walk you through construction loans, the available financing options and how you can qualify.

What is a construction loan?

A construction loan can be used to finance the entire cost of building a home from beginning to end. A construction loan can cover the cost of purchasing land, drafting plans and obtaining permits. It also covers the cost of labor and materials. Construction loans can be used to access contingency reserve funds, which are available if the project is more expensive than anticipated.

How does a construction loan work?

Future homeowners can use construction loans to borrow money to buy the materials and labor needed to build a house. These loans can be used to purchase the land that you’re building upon. The property you own may be used as collateral to your loan. Construction loans are generally issued for 12-18 months because they are designed to cover the building process. Some loans are converted automatically into permanent mortgages after construction is completed.

Contrary to traditional mortgages construction loans cannot be secured by a home that is already built. Construction loans are not secured by a house. The approval and application processes for construction loans are therefore more complex than mortgages. Before you can get financing, your lender may want to see your architectural plans and assess your financial situation. A construction budget and timeline will likely be required.

You won’t get all the funds in one lump sum after you have been approved for a construction loan. Instead, the lender will make payments over a series of draws (or installments) to your builder as they work through various stages of construction. This is how construction loans work as a line credit. The construction timeline determines when draws are made. Your lender may send an inspector to check the construction status before each payment is made.

Most of the time, you only have to repay interest on the amount drawn and not on the total loan amount. Your lender may allow you to convert your construction loan into an unsecured mortgage once construction is completed. You can also apply for a mortgage, or end loan, to pay off your construction loans if this is not possible.

Types of Construction Loans

A home building process is not one-size fits all. To meet the varying needs of future homeowners, there are several types of construction loans available–primarily, construction-to-permanent and construction-only loans. Both homeowners who are completing extensive renovations on an existing property have different options.

Comparative Construction Loans

Type of loan

Construction-to-permanent loan – This loan finances construction of a home and then converts into a fixed-rate mortgage once the home is completed. Homeowners who are looking to lock in mortgage financing while reducing closing costs.

Construction loan – Lender provides a short-term, adjustable rate loan that can be used to construct a home. The loan must either be refinanced into mortgages or paid in full once construction is complete. This involves two applications and two closings. People who have substantial cash or who plan to pay the construction loan off with the sale and purchase of a new home.

The owner-builder is eligible for a loan. These loans are not available to a third-party contractor but to the owner-builder. The loans are only available to homeowners who can show experience as a homebuilder or hold a license.

Homeowners who are familiar with building houses and wish to become their own general contractors

Renovation loan Akin to a traditional home mortgage, renovation loans pay for major renovations or the purchase of a house. This is why the loan amount will be based upon the estimated value of the property after renovations.

Homeowners looking to make major renovations will be interested in a fixer-upper.

Rates for Construction Loans

As with other types of loans’ interest rates, construction loan rates can vary based on creditworthiness, size of loan, and term. In addition, interest rates on construction loans are usually variable. They adjust over the life of the loan using an index similar to the prime rate.

In other words, rates are typically one percentage point lower than standard mortgage rates. Today, you might find construction loan rates as high as 5% or 6%. Because construction loans don’t require a mortgage to be secured, they can be more risky than traditional mortgages.

How to get a Construction Loan

To get financing for your construction project you will first need to be approved to obtain a loan. The loan approval process is more complex than those for mortgages or other loans, as the loan cannot be secured by or collateralized with a home. Along with imposing traditional borrower requirements, lenders will also need to approve architectural plans, a projected construction timeline, and a budget.

You must have the following information in order to be approved for construction loans:

Good credit to excellent credit. Lenders require that borrowers have at least 680 credit scores to be approved for a construction loan. Some lenders require at least 720 credit score. Consider improving your credit score before you apply for a construction loan.

Have enough income to repay the loan. To verify this, your lender may request financial statements or other documentation showing your annual income.

A low ratio of debt to income. The borrower’s ratio of debt-to–income (DTI), is a ratio of all your monthly debt payments to gross monthly earnings. A lower DTI means that you will have more money to pay monthly construction loan repayments. For construction loans, lenders usually require a DTI ratio of no more than 45 percent to increase the probability that borrowers are able to pay their monthly payments.

At least 20% down payment When borrowing a construction loan, most borrowers will need to make a downpayment of at least 20%. Some lenders may require as much as 25% to 30% of the construction costs. While the exact requirements will vary from lender to lender, a down payment less than 20% may be required to purchase private mortgage insurance (PMI).

Construction budget and project approval. Lenders want as much information about your proposed project as they can. Documents such as a purchase offer for the land, detailed blueprints and specifications and a line-item budget in bank preferred format, a schedule of payments, and a signed contract with provisions for change orders will increase your chances to get approval.

Approval of a general contractor or builder. Also, the lender will need to verify that the architect and builder have been licensed, qualified, and insured. This could include providing copies of the builder’s resume, insurance certificates and proof that they are financially stable. It is also important to include details of each party’s responsibilities. This includes the general contractor, architect and others involved in the project.