Traditional mortgages are plentiful, but there's usually a catch: you can only use the money to purchase an existing home. Construction loans are distinct in covering the entire cost of constructing a new home, garage, or business structure. They can also help with renovations or land purchases (if you don't already own the property).
Important Points to Remember
- Construction loans are short-term loans used to purchase land and construct structures on it.
- Construction loans are similar to lines of credit in that they are closed when the project is completed.
- Once the work has been completed or the milestones have been met, payments are made to the contractors who did the work.
Construction Loans and How They Work
A construction loan is a real estate loan that is only for a short period of time. If your program allows, you can use the loan to buy land, build on an existing property, or renovate existing structures. Since you only receive the amount you need (in the form of advances) to complete each portion of a project, a construction loan is similar to a line of credit. As a result, you just pay interest on the amount you borrow, as opposed to a lump sum loan, in which you take all the money available up front and immediately pay interest on the entire balance.Payments
You typically make interest-only payments (or none at all, in some cases) based on your outstanding loan balance during the construction phase. Payments usually start six to twenty-four months after the loan is approved. Construction loans are less common than conventional home loans, but they are still available from a variety of lenders. If you're thinking about building, familiarise yourself with the fundamentals and how each lender approaches the details.Contractors' Reimbursements
As your project progresses and milestones are met, you or the builder can request draw payments for completed work. Inspectors must verify that the work has been completed, but they do not always evaluate the quality of the work. If everything is in order, the builder receives a payment.Funding on a temporary basis
Construction loans are typically short-term loans that are paid back with a "permanent" loan. When the construction is finished, the construction loan usually comes to an end. You get an appraisal and an inspection on the finished property, then refinance into a better loan to pay off the debt. The temporary nature of these loans can be dealt with in two ways: After the construction is completed, apply for a new loan. You'll need to meet the same requirements as if you were applying for a new mortgage. As a result, you'll need to show proof of income and creditworthiness in order to be approved. Set up both loans at the start of the process (also known as single closing). The construction-to-permanent mortgage is another term used by the FHA. Because the loans are bundled together, this method may reduce closing costs. You'd end up with a standard home loan after the construction was completed (such as a 15-year or 30-year fixed-rate mortgage). This is also a good option if you're worried about getting approval after completing the project. Tip: Construction loans have higher (and frequently variable) interest rates than conventional home loans.Stages
A construction loan can be used for almost any stage of the construction process, including land acquisition, excavation, foundation pouring, framing, and finishing. Depending on your lender's policies, you can also build garages, simple sheds, and other structures.Payment in Full
Don't expect to borrow 100% of what you need, as you would with most loans. Most lenders expect you to put some money down on the property, and some even demand a 20% down payment. Of course, you have the option of bringing cash to the table. However, if you already own land, you may be able to use it instead of cash as collateral.A Sound Strategy
You must qualify for a construction loan in the same way that you would for any other loan. That means you'll need good credit and low debt-to-income ratios (debt-to-income and loan-to-value). A 20 percent down payment is also preferable, though some exceptions exist. It's also crucial to show that you've been earning money consistently.Approval of the Lender
Since the bank must approve your construction plans, construction loans are unique. Approvals may be easier if you buy from a builder who regularly works with a specific lender. "Custom" projects, on the other hand, can be difficult. Tip: Don't plan on spending every penny the bank is willing to lend, and don't expect to be able to move out of your current home the day after the "projected" completion date. Expect your lender to ask for all of the project's details, including: Who is responsible for the work? What will the procedure be? (details should be conveyed in architectural drawings) What is the timetable for each of the phases? What is the total cost of everything? Will the structure comply with local building codes and regulations? Are you capable of completing the task? What if you want to build everything yourself? Unfortunately, this complicates matters even more. Banks are wary of working with home builders. Banks are concerned that non-professionals are more likely to experience delays and problems. You'll almost certainly have to hire someone else unless you're a full-time professional contractor with years of experience.Make Provisions for the Unexpected
Having a plan is great, but it's even better to have flexibility. Construction projects are known for their delays and unexpected outcomes, so make sure your budget and timeline allow for some wiggle room.Most Commonly Asked Questions (FAQs)
How much would it cost to construct a home on my property?
In 2020, the median contract price for new home construction was $298,500, according to the Census Bureau.What are the criteria for obtaining a construction loan?
The requirements, as with most types of loans, are set by the lender and are largely determined by your credit score and down payment. Construction loans are more likely to be approved if you have a good credit score and a large down payment. In general, construction loan requirements for both of these factors will be more stringent than traditional mortgage requirements.