Searching for the ideal house can be both enjoyable and difficult. There are numerous aspects to take into account when house hunting, such as the style, size, and location, which can make it challenging to begin the process.
Sometimes, this can result in finding houses that don’t fully meet your expectations. However, the good news is that if you can’t find the perfect home, you have the option to construct a new one that perfectly suits your needs. To fund this construction project, it is important to have knowledge about construction loans.
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What Is a Construction Loan?
Construction loans are a type of temporary funding specifically designed to assist in financing the various expenses involved in constructing a residential property.
These loans can be utilized to cover expenses such as purchasing land, creating architectural plans, obtaining necessary permits, and financing labor and materials.
Additionally, construction loans can also provide access to contingency reserves in case the project ends up being more costly than initially anticipated, or interest reserves for individuals who prefer not to make interest payments during the construction process.
How Do Construction Loans Work?
Construction loans typically have a duration of one year and are designed to fund the construction of a new home. Once the construction is finished, borrowers have the option to either refinance the construction loan into a long-term mortgage or obtain a new loan to repay the construction loan, which is often referred to as an “end loan.”
Alternatively, some borrowers choose a construction-to-permanent loan, where the construction loan automatically converts into a mortgage loan once the home is completed. During the construction phase, the borrower may be required to make interest-only payments on the loan.
In certain cases, construction loans may necessitate the full balance to be repaid before the project is finished. When individuals seek construction loans to build a home, the mortgage lender may choose to directly pay the funds to the contractor instead of the borrower.
Payment for the loan can be made in stages as each phase of the project is completed. Construction loans are not limited to new home construction, as they can also be obtained for financing renovation and restoration projects.
Eligibility Requirements for Construction Loans
Construction loans typically have stricter credit criteria compared to traditional mortgage loans because they lack collateral. Since the property being built does not yet exist, it cannot be used as security in case of loan default.
Local credit unions and regional banks are the usual providers of construction loans. Local banks are more knowledgeable about the housing market in their specific area and are therefore more at ease offering home construction loans to borrowers within their community.
When applying for a construction loan, it is common for lenders to ask for a minimum down payment of 20%, although some may require a higher percentage, such as 25%. If a borrower has a limited or tarnished credit history or carries a significant amount of debt, they may encounter difficulties in obtaining a construction loan.
In order to be approved for the loan, the borrower will need to provide the lender with a detailed list of construction specifications, often referred to as a “blue book.” Additionally, the borrower will need to demonstrate that a qualified builder is involved in the project.
Types of Construction Loans
Constructing a home is a customized process that caters to the unique requirements of each homeowner. To accommodate these diverse needs, there are different kinds of construction loans available, such as construction-to-permanent loans and construction-only loans.
Additionally, owner-builders and homeowners undertaking substantial renovations on their existing houses have distinct options to choose from.
Construction-to-permanent loan
A construction loan is a type of financing that covers the costs of building a new home and later transitions into a fixed-rate mortgage once the construction is finished.
Construction-only loan
A construction loan is a type of loan provided by a lender for the purpose of funding the completion of a home construction project. It is a short-term loan with an adjustable interest rate.
Once the construction is finished, the borrower needs to repay the loan in full or opt for refinancing it into a mortgage. This process involves two separate applications and two closing procedures.
Owner-builder loan
Construction loans are specifically designed for owner-builders, meaning that the funds are disbursed directly to the owner instead of an approved third-party contractor. These types of loans are typically accessible to individuals who can showcase their prior experience in homebuilding or possess a valid contractor’s license.
Renovation loan
Construction loans are similar to traditional mortgages and are specifically designed to cover the expenses of purchasing a property and carrying out significant renovations. These loans are unique in that the loan amount is determined based on the estimated value of the home once the renovations are completed.
What Does a Construction Loan Cover?
A construction loan is a type of financing that provides funds to cover all expenses associated with building a new home, including the purchase of land, obtaining building permits, paying for labor and materials. Similar to other home loans, construction loans also include closing costs.
Construction Loan Rates
Similar to interest rates for different kinds of loans, the rates for construction loans can vary depending on factors such as the borrower’s creditworthiness, the loan amount, and the loan duration. Additionally, interest rates for construction loans usually fluctuate as they are adjustable, meaning they change during the loan period based on an index like the prime rate.
Construction loans typically have interest rates that are approximately one percentage point higher than standard mortgage rates. Currently, it is common to find construction loan rates ranging from 5% to 6%. The reason for these higher rates is that construction loans do not have the security of a completed home as collateral, making them riskier compared to traditional mortgages.
How To Get A Construction Loan
Curious about how construction loans are obtained? Let’s simplify the process into a series of steps.
1. Choose A Builder
When starting your search for a lender, it is important to first select a skilled builder for your upcoming home construction project. Take the time to carefully evaluate any potential contractors you are considering.
This can be done by reading reviews online, inquiring about their qualifications, and examining their past construction projects to determine if they are the best fit for your requirements.
2. Gather Your Paperwork And Choose A Lender
When looking for a construction loan, it is important to search for a lender that offers the best terms for your specific needs. Similar to a regular mortgage, it is advisable to compare different lenders.
It is essential to have all the necessary documents prepared, such as the contract with your chosen lender and comprehensive plans outlining your home’s budget and construction details.
3. Start The Approval Process
Securing preapproval for a construction loan is a crucial milestone in guaranteeing your ability to finance the necessary funds for constructing your ideal home.
Similar to applying for a conventional mortgage, you will be required to submit various financial documents such as tax returns, W-2s, and bank statements.
4. Purchase Homeowners Insurance
While you may not be residing in your under-construction home, it is highly likely that your lender will insist on you having homeowners insurance that includes builder’s risk coverage as a prerequisite for loan approval.
Pros and Cons of a Construction Loan
Construction loans require a significant commitment of both time and finances. Prior to seeking a construction loan, it is important to evaluate the pros and cons associated with this type of financing.
Pros
- Construction loans are determined by either the project itself or the estimated future value of the property.
- During the construction period, you are only required to make interest payments due to the short repayment term of the construction loan.
- Construction loans are a beneficial choice for existing homeowners who desire to construct a new home but lack sufficient equity to qualify for a home equity loan or line of credit.
Cons
- Construction loans have a predetermined loan amount, which means that borrowers have limited flexibility if they encounter unforeseen expenses.
- At the completion of the construction process, the borrower is required to repay the entire amount of the construction loan. In cases where the construction loan does not automatically transition into a permanent mortgage, the borrower will need to obtain a new loan to cover the outstanding balance. This would entail incurring additional closing costs and fees for both the construction loan and the new loan.
- When it comes to construction loans, the interest rates you’ll incur are typically higher in comparison to other available loan options.
The Bottom Line
If you are looking to build a one-of-a-kind home but don’t have a large sum of money readily available, a construction loan might be the solution you need.
However, in order to be eligible for this loan, you must be ready to demonstrate to a financial institution that you have a comprehensive project plan in place and a skilled contractor who will oversee its execution.