How do construction loans work?
Some dream homes are made, not found. While a good old-fashioned house hunt could land you the home you’ve always wanted, sometimes the housing market can’t give you everything you want.
When you know exactly what you need in a house, but can’t find a suitable listing, your next best option could be to build it yourself. “But,” you protest, “that’ll cost a lot more money!” Very true, but that’s why construction loans exist: to help homebuilders finance new residential properties.
You may think only professional developers have access to these financing options, but any consumer with the right financial credentials can take advantage of construction loans. Here’s everything you need to know about this unique loan option.
What is a construction loan?
Building a new house may seem prohibitively expensive compared with buying an existing home, but you don’t necessarily need to pay for the entire construction all at once and upfront. There are special financing vehicles, known as construction loans, that can help you get the funds needed to build the home of your dreams.
Construction loan definition
In real estate, a construction loan is a specialized type of loan used to finance building residential property. They may also be called self-build construction loans, home-building loans , construction mortgages, “one-time close loan” or “two-time close loan.” Either a professional builder or a consumer homebuyer can take out a construction loan for the purpose of building a house.
What can you spend that money on? Whatever building costs you accumulate: architectural design, permits, materials, labor, excavation, foundation, structure, perhaps even the land or lot itself — you name it. In most cases, your builder will be given lump-sum payments at key stages throughout the building of the home to cover expenses. Once the funds are secured, there isn’t much for you to do as the homebuyer but sit back and let your builders work.
Construction loan vs. standard purchase loan for a new construction home
This is a pretty big misconception in the real estate industry. People often think they always need a construction loan to finance the purchase of a new-build property in order to pay the builder. That’s not the case, though. In many scenarios, such as buying from a subdivision or tract-style homebuilder who is constructing several — or even hundreds — of homes in one neighborhood, you would likely secure a more common home loan from your lender of choice. In this case there are generally more affordable down payment options that go as low as 5% of the sale price.
A construction loan, meanwhile, comes into play only when you are financing the building of a new home with a builder who requires the buyer to make large payments at various stages throughout the construction process, i.e. foundation, framing, drywall, cabinetry install, etc. It’s very important to understand the distinction between these two financing options as they apply to extremely different situations.
How do construction loans work?
After you’ve acquired a parcel of land to serve as the site of your new home, you or your builder will need to go out and get a construction mortgage loan. Not all mortgage lenders offer these types of loans, but your builder should be able to point you in the right direction.
Once financing has been extended, the clock starts ticking. Unlike mortgages, which often run for a long, long time (hello, 30-year fixed rate home loans), self-build loans are very short-lived. In many cases, borrowers will be required to repay the loan within one year. And while you might not need to make payments on the principal — i.e., the loan amount — until the build is completed, you’ll likely be on the hook for interest payments each month. In many cases, this temporary loan can then be converted into a more traditional loan, such as the above-mentioned 30 year fixed rate home loan. Be sure to ask this question of your lender before you start building your new dream home!
To complicate matters even further, home building loans typically have higher interest rates compared with just about any type of mortgage, whether it’s a fixed rate, adjustable rate or even jumbo loan.
Also, keep in mind that you may never actually see the funds from new construction loans. It’s pretty common for lenders to send that money directly to the builder to pay for construction costs. The only time the lender would likely pay you rather than your builder is if you were using an owner-builder loan rather than a traditional construction loan — but we’ll get into that later.
Where do mortgages come into play?
So, where do mortgages fit into the picture? You won’t apply for a home loan until after you’ve completed construction on your new home. In fact, you’ll actually have two closing dates: one for the construction loan and one for your mortgage.
Does that mean you need to fully repay your house building loan before taking out a mortgage on your house? Not necessarily. You could refinance your construction loan to fold it into your mortgage, paying off the balance each month over the length of your home loan.
That being said, some lenders and construction loans products do require borrowers to repay the balance in full once the project is finished. Always work with your lender to fully understand the terms of any loan so you know what your responsibilities are as a homebuyer.
How do you qualify for a construction loan?
Like any type of financing, you’ll need to meet certain criteria to qualify for a construction loan. Don’t be surprised if lenders have stricter requirements on a house construction loan than they might with certain mortgage products. While specific qualifications for self-build loans will vary from lender to lender, these are usually the areas they’ll scrutinize the most:
- Credit score
- Debt-to-income (DTI) ratio
- Available funds
One way construction loan qualifications stand out in the real estate lending world is with construction plan requirements. Lenders may want to see a detailed layout of your home building plan before agreeing to loan you the money to go out and actually build it. Think of it like a small business loan: No bank is likely to loan you money for a business venture without first seeing a business plan showing that those funds will be put to good use.
A conventional mortgage doesn’t require that kind of in-depth documentation — at least not to the same degree. The closest comparison might be home appraisal requirements, which verify that the property itself will provide adequate collateral on the home loan.
Do construction loans require a down payment?
Zero-down-payment loans are rare in the mortgage industry. Unless you qualify for a VA loan, you should usually expect to put something down on a new purchase. In the case of a construction loan, that something can be a rather large chunk of money. Lenders often offer down payment options that bottom out at 20% of the purchase price on new home construction loans. And there’s no wiggle room to pay mortgage insurance to offset lower down payments, as you might with a traditional home loan.
Of course, there are exceptions to those construction loan down payment requirements. Certain government loan programs, like the Federal Housing Administration’s (FHA) One-Time Close Loan, may offer more flexible lending options. In the case of the FHA program, you may be able to use down payment options as low as 3.5%.
The Department of Veterans Affairs’ loan program is another notable exception. Qualifying borrowers could receive a VA construction loan with no down payment at all.
Again, not all mortgage lenders offer financing to build a home, and even fewer are approved for FHA construction loans or other government programs. So, these kinds of loan offerings, while enticing, may not be available to all homebuyers.
What types of construction loans are available?
We noted earlier that homebuyers often mix up construction loans and loans on new construction. At the risk of making things even more confusing, you should know that there are actually different types of construction loans to consider as well. Let’s take a look at your home build loan options and see how they compare:
- Construction-only loan
- Construction-to-permanent loan
- Owner-builder loan
This is the most basic form of a construction loan. It covers the costs of building the home and nothing else. Once development is finished, you’ll either need to repay the remainder of your loan balance or refinance the loan and bundle everything into your mortgage.
There are also a few government programs that support construction-only loans, most notably the aforementioned FHA and VA construction loan programs. Note that these government agencies do not provide funding themselves — you’ll still need to go through an approved lender to get financing.
While your standard construction loan exists as a wholly separate financial vehicle from your mortgage, there are some options that combine the two loans. A construction-to-permanent loan does just that, first providing the financing to pay for building costs and then repackaging the remaining debt into a home loan. Unlike a true construction-only loan, you won’t be required to complete two separate loan applications with this option. That also means you’ll only pay one down payment and one set of closing costs.
As we’ve discussed, the funds from a construction loan usually go directly to your builder. But, if you’re a professional contractor or homebuilder yourself, you may qualify for an owner-builder loan and receive that money yourself. This option would essentially remove a third-party contractor from the equation completely.
That could be one less complication to deal with, but it also means you alone will be responsible for building your new home. Not just anyone can get an owner-builder loan, either; you’ll need to show your lender that you have the qualifications and experience to take on such a massive development project.
How do construction loan interest rates compare to mortgage rates?
You may recall that interest rates on construction loans typically run a bit higher than conventional mortgage rates. It’s hard to say for certain precisely how much higher construction loan interest rates will run, because it really comes down to the lender and their particular appetite for risk.
Keep in mind that lenders will usually view a new construction as a more risky investment compared with an existing building. There are just so many unknown variables to account for, from build quality and workmanship to material availability and construction scheduling. From that vantage point, it makes sense that lenders would want to offset some of the increased risk they’re taking on (even if it’s only perceived risk) by setting higher interest rates on these loans.
The good news is you may be able to refinance the loan once the build is completed. A refi could essentially allow you to bundle your self-build loan into your new mortgage. Now, that would mean you’d have a larger home loan amount than if you kept them separate. But, it would also mean your interest rate would, in all likelihood, be significantly lower on the combined refi.* And that, in turn, would lead to less interest due over the life of the loan — not to mention, lower monthly payments.
Avoid these 5 common construction loan missteps
Factoring in a new build adds a whole additional layer of complexity to the mortgage process — which isn’t exactly known for its simplicity to begin with. As such, mistakes are common, even with the assistance of experienced builders and real estate agents. To keep everything running smoothly, keep an eye out for these five construction loan missteps:
- Failing to deliver a detailed building plan to your lender
- Creating an overly aggressive construction schedule
- Waiting until the lot is acquired to shop for builders
- Forgetting to get preapproved on a loan
- Choosing the wrong type of construction loan for your needs
When does it make sense to finance building a new house?
We won’t sugarcoat it: Getting a construction loan and building a new house is a major undertaking. Many prospective homebuyers won’t want to deal with the potential headaches and complexities that new construction loans present, but there are instances where it may make perfect sense to build rather than simply buy:
- You want to customize every aspect of your new home.
- The current housing market doesn’t come close to giving you what you’re looking for in a new house.
- You have the perfect location for your dream home — you’re just missing the actual house.
- You have enough funds available to cover the cost of two down payments: one for the construction loan and one for your mortgage.
- You’re working with a builder you trust to complete the project on time and on budget.
- Your lending credentials — credit score, DTI ratio, etc. — are strong enough to net favorable loan terms for both your construction loan and your mortgage.
With a construction loan, you can finance building a new house from the ground up. A home building loan is a completely separate type of financing vehicle from your traditional mortgage, and you’ll need to get both if you choose to go this route.
Lenders often use much more rigorous criteria when vetting borrower credentials on construction loans, so you’ll want to be sure your lending profile is as strong as possible before applying for this kind of financing. And given the relatively tight timeline you’ll be working within — projects frequently need to be completed within a year — you’ll want to have all of your ducks in a row beforehand.
There’s no question that building a house with a construction loan is more complicated — and more expensive — than simply purchasing an existing property. But if you can’t find what you’re looking for in today’s real estate market, it’s good to know there are other options to explore. Before you get in too deep, be sure to consult a loan expert who can assess your specific situation, answer your questions and help you make the best decision given your circumstances.
*Savings, if any, vary based on consumer credit profile, interest rate availability, and a variety of factors.
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