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Home Construction Loans: How They Work

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Home buying is an exciting time—that is until you hit a dead end. While looking for a home, you may be trying to find one that checks off all the most important things on your list, from multiple bedrooms to a spacious backyard. Unfortunately, you can’t have it all. The current housing market is incredibly competitive and you must master the art of compromising if you wish to buy property. You might be ready to give up your search, but know that your dream home is closer than you think. It’s finally time to stop fantasizing about the house you want and start making it a reality with a home construction loan.

Building a home means living somewhere that’s as unique as you. However, like any aspiration, it’s not an easy feat to accomplish. Home construction loans are riddled with complications. In this guide, we’ll walk you through the important details of home building loans. Keep reading, so you’ll be ready to have the house you’ve always wanted. If you’re interested in a particular section, you can skip ahead using the links below.

What Is a Construction Loan?

A construction loan is a high-interest, short-term loan used to finance the costs associated with building a home from the ground up. These loans can also be used to renovate properties. Funds will only be available as long as construction is ongoing, typically one year or less. Depending on the type of construction loan you have, you’ll be able to refinance it into a permanent, long term mortgage or pay it off completely once construction is finished. 

How Do Construction Loans Work?

Standard home mortgages and construction loans are both used to make you a homeowner, but they work in very distinct ways. Most notably, the lender will pay builders, not borrowers, in intervals called draws. You’ll be working in tandem with each and the draw schedule will be agreed upon between the three. Another determining factor for payments will be construction phases, such as laying the foundation, installing plumbing, or adding the roof.  

Before another draw is distributed, an inspector will arrive on-site to check building progress to ensure it’s on time. This will happen at every stage of construction. During this time, you’ll also be making interest-only payments based on the funds already used until construction is over. 

Types of Construction Loans

Construction loans are not made equal. Depending on the project and your specific needs, the type of loan you choose will differ. There are various loans to consider, each with its advantages, disadvantages, and requirements. Here are five types of home construction loans that you may run into as you shop around for a loan. 

Construction-To-Permanent Loan

Also known as a single close construction loan, a construction-to-permanent loan will convert to a standard mortgage once the building is complete. With this loan, you’ll only be required to submit one application and pay closing costs once. At closing, your mortgage rate will be negotiated and fixed. Financing construction and your mortgage is a lot simpler and cheaper this way. Additionally, you won’t have to endure another round of tedious paperwork.

Construction-Only Loan

As the name implies, a construction-only loan will exclusively cover the construction of your home. Because the loan is short-term, you’ll have to apply for a permanent method of financing once construction is over. This means submitting two separate applications in a span of one year or less. Don’t forget the closing fees associated with this as well.

Although you may have to do more paperwork and provide extra documents, construction-only loans will give you the freedom to shop around for a better mortgage. But remember, your financial situation might drastically change just as you’re getting ready to apply for it. If you lose your job, default on credit card payments, or anything of the sort, you won’t be able to qualify for a home loan.

Renovation Loan

Financing home improvement projects is possible with a renovation loan. You can use this loan on homes that need a little TLC instead of starting from zero. These properties are considered fixer-uppers, and whether you’re looking to live in it or resell, they’re worthy investments if done right. A rehab loan, such as a 203(k), will provide you with the funds to purchase and improve the home. 

If you’re already a homeowner and want to do a few renovations, you can refinance your mortgage to receive a renovation loan and complete the necessary changes. Other options include getting a personal loan or opening another line of credit to tackle home improvement projects. 

Owner-Builder Construction Loan

If you want to save money, then you should consider an owner-builder construction loan. Instead of having to hire costly contractors, you’ll be the one in charge. However, this option is not available for everyone. You must have the required licenses, permits, and insurance, as well as construction experience.

End Loan

An end loan is a different way to refer to your mortgage. Once construction on your property is complete, you’ll have to pay off the end loan. To get an estimate of your payments, use a construction loan calculator.

What Do Construction Loans Cover?

Home construction loans will help you tackle the financial barrier between you and the building of your home. But, what exactly is covered under a construction loan? Your loan will be used to pay

  • Land costs
  • Labor 
  • Materials 
  • Permits
  • Fees
  • And More 

If there’s money left over once construction is complete, you won’t be able to use it to purchase furniture or decor. However, the money can be applied to permanent fixtures, appliances, and landscaping. 

How to Get a Home Construction Loan

Even though the application for a construction loan may be similar to a standard home mortgage, a construction loan is much more complicated.  Here’s a brief step-by-step overview of the construction loan process:

  1. If you’ve decided that a new-built house is right for you, begin to research knowledgeable builders within your area and meet with them. Ideally, the builder is going to have experience constructing the type of property you want and hold the necessary licenses and insurance policy.  Once you’ve narrowed down your choice, ask for a detailed plan. 
  2. Decide on the type of construction loan you want and search for experienced lenders offering the best rates. During this time, you should also set up an introductory meeting or phone call to discuss your project. 
  3. Provide the lender with important financial documents, including your W-2, tax returns, and bank statements.
  4. When you’re approved for the loan, you’ll meet to submit a down payment and pay closing costs.

Remember, this is a brief overview of what you’re construction loan process may look like. Your loan type, lender, and subcontractors could alter the steps above. 

Rates

Construction loan rates depend on the type of loan you get. For instance, a construction-only loan rate will be greater than a construction-to-permanent loan. All construction loan interest rates, however, are going to be higher than standard mortgage rates because there’s a lot more risk involved. 

With a traditional mortgage, lenders will use the property as collateral should you default on the loan. Home construction lenders don’t have anything to seize if you’re unable to pay. Using a home construction loan calculator will help you determine your DTI and gauge whether or not you’ll be able to repay the loan.

Requirements

To secure financing for your dream home, you’re going to need the following construction loan requirements: 

  • Credit score of 680 or higher
  • Construction loan down payment of 20% or more
  • Debt-to-income ratio (DTI) under 45%
  • Project timeline

Lenders are going to want to see a detailed building plan and realistic budget before any paperwork is submitted. To get their approval, make sure you take the time to research reputable construction companies. Lenders will request to view their proof of insurance and work history. Just as if you were applying for a traditional mortgage, you should have a steady source of income and your credit should be in tip-top shape.

If you didn’t qualify for a construction loan, don’t be discouraged! To increase your chances of getting approved next time, try the following tips:

  • Pay off hefty loans, like credit cards, student loans, and car loans, on time. If you can, aim to pay off smaller accounts in full
  • Avoid opening new lines of credit or making big purchases, such as buying a car

Bottom Line

If you can’t seem to find the perfect house to settle in, construction loans are a great way to obtain your dream home. Although these loans have multiple hoops that you have to jump through, taking the time to understand the requirements will make all the difference. You also want a proficient team that’ll support you in your endeavour and see it to the end. You’ll be working in tandem with builders and lenders, so it’s important to communicate your expectations often. With that said, be patient during the first few encounters with either as there may be a lot of back and forth. 

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