What Is a Construction Loan and How to Choose the Right One for You
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Your funds will be disbursed in chunks—called draws—as your home’s build progresses
Building a home comes with many perks. You can pick your lot, customize your floor plan and build the home of your dreams. Plus, with low housing supply and higher mortgage rates keeping many homeowners from listing their properties, it can also make your home purchase easier on the whole—no scouring listings or bidding wars necessary.
Still, financing a custom-built home isn’t the same as buying one off the street. With new construction, there’s not just one, single price tag you’ll need to cover. Instead, it’s a series of costs—often pricey ones—spread over an extended period.
Unless you have a savings account flush enough to foot the entire home-construction bill yourself, you’ll usually need a construction loan to bridge the gap. A construction loan is a type of mortgage that can fund the process of building your house—from the buying of the land and materials to covering the cost of the permits and labor.
“Construction loans can pay for most everything aside from furniture and other personal items,” says Chuck Meier, senior vice president of mortgages at SunriseBanks.com.
Are you thinking of building a home from the ground up? Here’s what you should know about construction loans before diving in.
How do construction loans work?
Home construction loans work differently than traditional mortgages. First, you’ll need to provide your lender with building plans, a construction schedule and estimated costs. All this will be used to set your loan amount.
Once approved, your funds will be disbursed in chunks—called draws—as your home’s build progresses. These are paid directly to your builder or contractor and are tied to specific build milestones or stages—when the foundation is finished or the framing is complete, for example. The lender will appoint an appraiser or inspector to check on the home’s progress before each disbursement.
“Draws compensate subcontractors and general contractors for the work they have completed during that period,” says Benjamin Kadish, president of Maverick Commercial Mortgage. “As the construction progresses, the loan amount increases with each construction draw, until it reaches the total promised by the lender.”
With construction loans, you’ll usually only pay interest on the amount you’ve drawn to date. This means as you make more draws—and as your build progresses—your monthly payments will increase. Payments typically start the month following your first draw.
To be clear: These are construction loans for custom-built homes—properties you build on spec from the ground up. If you buy from a builder in a development, you won’t need a construction loan. Instead, you’ll put down an earnest-money deposit—essentially claiming your chosen house and lot—and will close on a traditional mortgage loan once your home is complete.
Limitations of construction loans
Typically, construction loans last 12 months or less, meaning you’ll need to have your home construction completed within that time frame. If it isn’t, you may need to pay a fee to extend the timeline.
“There is an inspection process throughout the entire build process,” says Paul Catalano, vice president of commercial and mortgage lending at OnPath Federal Credit Union. “If the house isn’t progressing on schedule, then the bank would like to know why and what needs to be done to get the project back on track.”
You can also only use the loan funds for costs related to your home’s construction. This includes items such as:
- Building materials
- Architectural plans
For costs that come before your first draw is disbursed, you can pay out of pocket and count those costs toward your down payment. You can also save the bill and request it to be paid out of your first draw after closing.
Another important limitation to note: Certain types of construction loans may limit what builders and contractors you can use. With a VA loan for construction, for example, you can only use builders with an approved VA Builder ID. Most lenders also won’t allow you to build your own house (unless you’re a licensed builder/contractor yourself).
Construction loan rates
Generally, construction loan rates are slightly higher than the mortgage rates you would see on conventional loans since there’s no collateral (the house isn’t yet built). This increases the chance you’ll default, making them riskier for lenders.
According to Kadish, construction loan rates are usually about 1 percentage point higher than traditional term mortgages. So, at today’s average rates, you could expect to pay 8% or more for a construction loan, depending on your credit score and other factors.
Construction loan interest rates may be fixed or variable, meaning they move up and down based on the index the rate is tied to. Variable loans typically start with lower rates than fixed loans but can increase or decrease monthly depending on prevailing market rates.
Types of new construction loans
There are several types of construction loans to choose from. Some fund only the construction of your home and then end, while others transition into long-term mortgages once your home is complete. See below for the construction loan options you can typically choose from.
Construction-only loans are loans that are used to pay for just the construction of a house. Once that construction is complete, the total loan balance comes due. You can either pay it off in full or take out another loan (a traditional mortgage, for example) to cover the balance.
Keep in mind if you do this—and take out a new mortgage to pay off your construction loan—you will owe closing costs twice.
Construction-to-permanent loans are divided into two stages. First, there is the construction phase, which finances the cost of building your home. You’ll pay only interest while your home is being built.
Once the home is complete, the loan converts to a traditional mortgage, allowing you to pay off the balance owed over an extended period. Most buyers choose a 30-year fixed-rate loan for their final mortgage, though you can technically choose from a variety of terms and rate types.
These loans may come with one or two closings, depending on how the lender structures it.
Government-backed construction loans
There are a few government-backed loan programs that can help you fund your home’s construction, too. The USDA construction loan, backed by the Agriculture Department, is a construction-to-permanent loan option. USDA loans require your home be built in an eligible rural part of the country—where the population is 35,000 or less. Some lenders also offer VA construction loans, though only veterans, military members and in some cases their family members can qualify.
There are also two types of FHA loans that can be used toward construction costs: construction-to-permanent loans and FHA 203(k) loans. FHA 203(k) loans are technically renovation loans and can be used on existing homes that need to be rebuilt or repaired. They allow you to purchase the property and roll the costs of fixing it up all into a single loan.
How do you qualify for a construction loan?
“The financial institution needs to account for unexpected expenses and the project going over budget,” Catalano says. “So the borrower typically needs to show additional funds available in the event something happens.”
Beyond this, the exact requirements you’ll need to meet will depend on your loan program and lender. You will typically need a decent credit score (620 or higher), a debt-to-income ratio of 43% or less and a down payment (20%, in many cases).
Here’s the process you’ll need to follow to get a construction loan:
Find a lender and get preapproved. Not all lenders offer construction loans, so make sure you shop around. Pay attention to what types of construction loans the lender offers and verify that you meet the requirements (such as being a veteran for a VA construction loan). To get preapproved for your loan, you’ll need to submit tax returns, W-2s and recent bank statements and pay stubs. You’ll also need to agree to a credit check and have a rough idea of how much you’re looking to borrow for your build.
Find your builder. Hire a licensed builder or contractor in your area to draw up your home’s plans and estimate your construction costs. Your lender will likely vet them as part of your approval process, so choose one with proven experience and proper credentials. If you’re not sure where to start, your local branch of the National Association of Home Builders can help.
Apply for your loan. The next step is to fill out your lender’s full loan application and provide your construction contract, the architectural drawings/blueprints for your home and the itemized construction budget from your builder. The lender will use this information to determine your total loan amount.
Wait for underwriting. The lender will verify your finances and analyze your construction plans and estimated costs. They may also order an appraisal to assess the future value of your completed home to verify they are lending you the right amount.
Close on the loan and take your first draw. Finally, you’ll sign your loan paperwork, pay your closing costs and down payment and close on your loan. Your lender will also provide you with a draw schedule and disburse your first draw so that construction can commence.
Additional draws will typically occur once certain milestones are reached or you enter a new stage of the construction process. Your lender may require an inspector or appraiser to verify the build’s progress before your next draw can be disbursed.
All in all, a construction loan can be a bit more complicated than a traditional mortgage, but in today’s market—which has active home listings down compared with a year ago—the extra work will be worth it for some home buyers.
BY Aly J. Yale
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