How do home construction loans work? – The rolling pin

For many people, building their dream home is, well, a dream. When you want to make that dream a reality, chances are you need to build the house using a construction loan.

If you want to build your own home, here’s what you need to know about construction loans and how they work.

What is a construction loan?

A construction loan is what it sounds like a loan designed to help you build your home from the ground up. However, it is important to note that instead of being a long-term loan of up to 30 years, a construction loan covers the period that your home is under construction. Most construction loans mature in a year or less. Once the house is finished, you must repay the construction loan or obtain another larger loan (the actual mortgage) to pay off the cost of construction.

Your construction loan will include the following costs:

  • Land for the house
  • Labor and materials involved in building the house
  • Fees, permits and plans
  • Contingency reserves to cover unforeseen expenses
  • Interest reserves for those who do not pay interest during construction
  • Closing costs

It’s important to note that construction loans are often more difficult to obtain than a regular mortgage, so you should be prepared to take a few steps.

How to benefit from a construction loan?

Many construction loans come with higher interest rates than a standard mortgage. Also, depending on your situation, you may need to sell your current home before moving forward with the construction loan.

In general, you can expect to provide the following if you want to qualify for a construction loan:

  • Down payment of at least 20%: Even though you can usually pay less for a down payment on a regular mortgage, many lenders will not accept less than 20% for a construction loan because there is no house built yet, which means a bigger risk.
  • Higher credit score: Even though some mortgage lenders offer loans to those with a score of 620 (or sometimes lower), many construction loans require you to have a higher score, sometimes at least 680, even to qualify.
  • Steady income: You need to show a steady income to get a home loan, but that’s essential with a construction loan.
  • Debt to income ratio: Many lenders are stricter on this requirement for construction loans than for more traditional mortgages. The upper limit is usually 45%, but you may need to plan for a lower ratio than that.
  • Construction plan and schedule: You must provide your planned construction schedule. Lenders require you to have a logical plan and timeline for completing the project.
  • Manufacturer’s opinion: You should also have a builder in mind for the project. The lender could review the builder’s qualifications and past work and check the progress of your home.

You will need to have all of these elements in place for the most part before approaching your potential lender for money.

Types of construction loans

When deciding on a construction loan, consider the different types of loans available. Think about your long-term needs as you go.

Construction to permanent loans

This loan is probably the easiest type of loan to manage because it concludes the construction of your home and then converts your construction loan into a mortgage when the construction phase is complete. Sometimes these loans are called “once-closing” loans. You set the interest rate at the start of the project and keep it for the duration of the mortgage. If you have a simple building plan and want to convert to a mortgage when the house is finished, without getting another loan later, a build-permanent loan may be a good choice.

Construction loans only

Just as they sound, a construction only loan will only cover the construction period. You will need to close two different loans. First, you need to get the construction loan, and later, you will need to take out a mortgage. If you have significant cash reserves, you may be able to make this one work. Also, if you want to research a lender and possibly get a better interest rate later, a construction-only loan may work. Just be ready with your other financing in place so you can repay the construction loan only on time.

Resource:How to find the best mortgage rates

Renovation construction loans

If the home you’re dealing with needs major renovations, you may be able to get a construction loan to help cover those costs. This loan may be an option if you are buying a repairman instead of building a house from scratch. With major renovations, you may still need a larger down payment. You may also need to provide a construction plan and schedule, as your loan will be based on the projected value of the home once the renovations are complete.

Banks that offer construction loans

Not all banks offer construction loans. If you are hoping to build or renovate a home, you should seek out a lender that offers this type of financing.

  • TD Bank: Offers flexibility with different options, including one-time closing loans.
  • National Mortgage Lending Group: Provides different options including lower credit score requirement.
  • BB&T Bank: Different types of loans, including construction-to-permanent.
  • VA Nationwide Home Loans: Provides the ability to use VA benefits to obtain financing for construction loans.

Have all your documentation ready in advance. Also be prepared for regular inspections and continue to obtain permits throughout the construction process. Knowing the requirements can help you get your construction loan approved.

FAQs

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Conclusion

Getting a construction loan is a complex process that can take a lot of time and effort. Before applying, be sure to carefully read the section above on how to qualify. Then, gather all the necessary documentation in advance. The more you prepare in advance, the easier it will be to avoid surprises.

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