Construction loans: What are they and how do they work

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Construction loans: What are they and how do they work

A great way to personalize your home is to build it from scratch. Construction can be expensive, just as buying a house. Construction loans are a way to get the money you need to purchase land and pay the labor and materials needed for building a house.

There are many types of construction loans available, so the application and approval process can be more complicated than for traditional mortgages. We will help you understand construction loans and walk you through the process, including how to apply for financing.

What is a Construction Loan?

A construction loan is short term financing that can be used for the cost of building a house from start to finish. Construction loans can be used to cover costs such as buying land, drawing plans, getting permits, and paying for labor and materials. A construction loan can also be used to access contingency funds if your project is more costly than expected.

How do Construction Loans work?

Future homeowners can borrow money for construction loans to buy materials and hire labor to build their home. This money can also be used to buy the land on which you are building. You may be eligible to use your property as collateral for your loan if you already own the land. Construction loans are typically issued for 12 to 18 months. They’re generally intended to finance the construction process. Some loans can be converted into permanent mortgages once construction is completed.

Construction loans can’t be secured by a house, unlike traditional mortgages. The application and approval process for a construction loan are much more complicated than a mortgage. Before approving your application for financing, your lender will likely inspect your plans and review your financial situation. A budget and estimated construction timeframe will also be required.

Once you are approved for a loan for construction, you will not receive the entire amount in one lump sum. Instead, the lender will pay your builder via a series or installments as they finish various stages of construction. Construction loans can be thought of as a line-of credit. Your lender will likely send an inspector to assess the progress of construction before scheduling draws.

Most cases you will only have to repay the interest on the funds that were drawn, and not the entire amount. You may be able to convert your construction loan into mortgage depending on the lender. To pay off your construction loan, you may be eligible for a mortgage (or end loan) to cover the cost.

Different types of construction loans

It is not an easy task to build a home. To meet the varying needs of future homeowners, there are several types of construction loans available–primarily, construction-to-permanent and construction-only loans. There are separate options for homeowners and owners who want to make extensive renovations to an existing home.

Comparative Comparison of 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 wish to lock in mortgage financing and save closing costs

Construction-only Loan – Lender offers a short-term adjustable-rate loan to help complete construction of a house. The loan must be refinanced or paid off in full after construction is completed. Two closings and an application process are required. If you have large cash reserves or plan to repay the construction loan through the sale of your previous home, this is a good option.

Owner-builder loan. Drawings are made to the homeowner-builder and not to an approved third party contractor. Owners who have experience in homebuilding or have a contractor’s licence are typically eligible for these loans.

Homeowners with experience building homes and who want to be their own general contractors

Renovation loan – Unlike a traditional mortgage, these loans are used to finance major renovations and the purchase of a home. The loan amount is determined based on the expected value of the home after renovations.

Homeowners buying a fixer upper with the intention of investing in major renovations

Construction Loan Rates

Rates on construction loans are similar to interest rates for other types loans. They vary depending on the borrower’s creditworthiness, loan amount, and loan term. Additionally, construction loan interest rates are often variable. This means that they can change over time based on an index like the prime rate.

Rates are usually one percentage point higher than standard mortgage rates. Construction loan rates can be as low as 5% to 6% today. Construction loans are riskier than traditional mortgages because they are not secured by a home that is already built.

How to get a construction loan

You will need to be approved for a loan before you can obtain the financing you need to begin your construction project. Because the loan will not be secured or collateralized by a home, this approval process is usually more stringent than that for mortgages and other loans. Lenders will not only have to approve traditional borrower standards but also review and approve architectural plans and an estimated construction timeframe and a budget.

You will need the following documents to be approved for a loan construction.

Excellent to good credit. In order to reduce risk, lenders require that borrowers have a minimum credit score 680 in order to be eligible for a loan. Some lenders will require that you have a minimum score of 720. Before applying for a loan to build a home, you should take the time to improve your credit rating.

You should have sufficient income to repay the loan. Your lender will request financial statements and other documentation to confirm your income.

Low debt-to income ratio. This is the ratio of your monthly debt payments and your gross monthly income. Your DTI ratio will determine how much cash you have each month to pay construction loan payments. Lenders typically require that the DTI ratio is no more than 45% to issue construction loans. This increases the chance that borrowers can afford their payments.

Minimum 20% down payment When taking out a loan for construction, borrowers are usually required to pay a minimum of 20%. Many lenders will require a down payment of between 25% and 30% of total construction costs. Lender requirements vary, but you might need to pay private mortgage insurance (PMI) if your down payment is less than 20%.

Construction budget approval and project. Due to the uncertainty involved in building a home, lenders need as much information as possible. You can increase your chances of approval by providing documentation such as a deed for the land, blueprints and specifications, and a bank preferred format line-item budget, a payment schedule, and a signed construction agreement with changes order provisions.

General contractor or builder approval. You will also need to prove to the lender that your architect/builder is licensed, insured, and qualified. You may need to provide copies of the builder’s insurance certificates, resume, and proof of financial stability. Include a description of the responsibilities of each party, including the general contractor, architect, and any other involved in the project.

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