everything you need to know about construction loans
With a shortage of homes for sale on the market, you may be looking to build your new dream home. Building your own home can be a tremendously rewarding experience. You get to make choices about everything from location and floor plan to colors and landscaping. At the end of the process, you have a truly special place to live, something uniquely yours. But how do you pay for it? And how do new construction loans work?
While a project like building your home can be both exciting and fun, there are many things to consider before you begin building. Probably the most important consideration is how this type of project gets paid for.
what is a construction loan?
A home construction loan gives you the funds needed to build a house on a piece of land, typically for one-year, during the construction period. Construction loans are used to cover all sorts of things that go into building a home: land, labor, permits and building materials.
Depending on the lender you choose, there can be different requirements you'll need to meet or limitations that you might find with the loan. For example, a construction loan doesn't usually cover the home furnishing aspect of a home, although it may cover things like permanent fixtures throughout the walls of the interior and necessary appliances, such as fridges and washing machines.
Home construction loans are used when you have purchased a piece of land and are ready to build. A land loan is often used when you want to buy land but aren't quite ready to construct your dream home.
the construction loan process
Unless you have the cash on hand to fund your construction project, you are going to need a construction loan in order to finance the cost of the building project –and sometimes the purchase of the land itself.
A construction loan is a short-term loan that covers the cost of construction until the home is complete, and a traditional mortgage can be taken out. However, it’s important to note that this type of funding isn’t the easiest to obtain; largely because this type of loan is considered far riskier than a traditional mortgage. New construction financing differs from resale finance because the home itself doesn’t exist. This means if the payments stop and the lender needs to foreclose, they must finish constructing the house first. Naturally, this makes construction loans riskier and lenders more wary.
Generally, construction loans are issued by a financial institution, such as a credit union, rather than a mortgage company. Keep in mind that these loans will require a 20-30% down payment and the interest rates on these loans tend to be higher than traditional loans, so you’ll want to shop around to find the best option before you sign on the dotted line.
If you’re on the fence about building your own home – and curious about funding options, here’s a look at what you should know about new home construction loans.
different types of loans for different types of homes
First, it’s important to note that there are two basic types of loans available based on the type of home that you are going to construct. The first is custom home financing, which is where the buyer builds their home on property they own and the buyer secures the construction financing. The second is going through a tract home builder – which is where a larger builder will obtain construction financing on their own.
tract home builders
In very rare cases, the builder will be willing to carry the financing for the project. But this is usually only the case with large tract builders. With this option, you’d lose the flexibility that you’d have with a custom builder.
Here’s how it works: Tract home builders handle the construction portion of their financing, and they own the home throughout the entire building process, and then at completion, they transfer the title to the buyer. This type of builder pays for the lot and then builds the house to your specifications. When it’s done you close on a permanent 15 or 30-year mortgage.
custom home financing
This type of financing differs from tract style or production home financing, in that the buyer generally owns the land that the home is being constructed on and the buyer is responsible for the construction loan. With this option, the builder is contracted by the homeowner to build the house, so you’d have a lot more freedom in terms of how the house is built.
At closing, the buyer pays off the construction loan with a permanent 15 or 30-year mortgage.
types of construction loans
Construction Loans are usually short-term higher interest loans that last until the home is completed. In most cases, the lender pays the funds directly to the contractor, rather than the borrower. These payments – also known as draws – often come in installments at different stages of development, rather than all at once.
Now, let’s get more specific, and look at some of the different types of custom home financing that are available today.
construction only loan
Buyers who choose a construction only loan are usually looking for the best deal possible on the permanent loan. With this loan, the lender will typically offer enough money to cover the cost of the project, and the borrower will usually make interest-only payments until it’s complete. The principal balance is commonly due in full once the project is complete, or one year later. This allows the borrower the freedom to apply for a mortgage once the project is complete. If the buyer chooses this route, make sure you know what to ask your lender before choosing a loan product.
Construction-to-permanent loans are very popular with homebuyers. With this type of loan, the buyer takes out a loan from the lender that’s essentially a line-of-credit, and the builder can draw from it at each stage of construction. There are on-site inspections at the various draw stages. At the end of the draw period, the construction loan converts into a permanent amortized loan.
The construction-to-permanent mortgage loan usually covers the cost of the construction project and the mortgage on the completed property. An interest-only payment during the construction period is typical with this type of loan. There is only one closing with this type of loan because the borrower will be working with the same lender for the construction and the mortgage loan. The interest rate is usually the same for both loans and there may be a penalty if construction exceeds one year.
The single-close loan eliminates a second set of closing costs. This loan requires only one application and once it’s approved, there is no secondary approval process required.
VA and FHA construction loans
There are VA and FHA construction loans available as well. However, these loans can be difficult to qualify for, and may be hard to use because of loan limits. At the end of construction, you’ll usually move into what’s known as permanent financing. At this point, you’ll also have the option to pay off the loan or convert it into a traditional home mortgage.
what are the requirements for a construction loan?
In order to be approved for a construction loan, there are some terms and conditions that need to be met. Each lender will have different criteria that the borrower will need to meet, as a self-build loan is much riskier than traditional mortgages, the standards can be strict. As always make sure you speak with a lender before you begin, to see what they specifically require for you to qualify.
Generally, though, they’ll want to see the following items:
First up, the lender will want to see that you’re working a qualified builder. This means a construction company or a licensed general contractor who has a solid reputation for building quality homes. If you’re planning on being your own general contractor, you may have a difficult time being approved for a home construction loan.
Next, it’s not enough to simply request a loan – you’ll need to provide the lender with detailed plans and specifications, including everything from materials that will be used – such as insulation and roofing, as well as ceiling heights and room dimensions. These plans should be professional architectural drawings.
value estimated by an appraiser
The value of the home will be assessed by a licensed appraiser. The appraised value will be based on the plans and specifications and the value of the lot. These calculations will then be compared with comparable homes in a similar location.
proof of income
Be prepared to provide proof of income in the form of W2s and pay stubs; or tax returns, profit/loss and balance sheet if you’re self-employed.
Lenders will also want to make sure that the loan-to-value (LTV) isn’t more than 90%, including the value of the land. Many lenders will not disperse more than 80% of the value, prior to the completion of construction.
healthy credit score
You’ll also need a good credit score. A score of at least 680 or 700 will generally be required.
what does the lender need from the builder?
In addition to the criteria you’ll need to meet as the buyer, here are some things the lender will need to see from the builder as well:
- Project description
- Building license
- Proof of Insurance
- Banking information, profit and loss statement
- Budget for project
- Signed contract with buyer
- Job cost
construction loan calculator
Just like with conventional mortgages, you can find numerous construction loan calculators online. From simple to complex, there are many options out there for you to work with. Or you can reach out to your construction mortgage lender, who will help you calculate the conversion of the loan from construction to a traditional mortgage, and will provide you with the monthly principal and interest payments on that portion of the loan as well. To get a final number, you will need to know the following information:
- Price of the lot/property
- Cost of construction
- Duration of the project
- Approximate appraised home value of completed home
- Estimated interest rate on the loan
construction loan down payment
The down payment is based on the lesser of the appraised value or the cost of construction plus the lot.
For example, if the appraiser determines the finished home to be appraised at $300,000, you can estimate that the credit union will lend you 80% or $240,000. The down payment will end up being the cost of construction minus the value of your loan. So, for this example, your down payment will be $300,000 – $240,000 or $60,000. This method will give you an approximation for your down payment. If money is tight, and you need a more exact determination, contact a lender and talk specifics with them directly. Lenders can always give you a more detailed analysis including current rates.
construction loan closing costs
Just like with purchasing an existing home, many new home buyers are surprised by the closing costs. Closing costs for new construction includes fees for items like origination fees, home inspection fees, home appraisal fees, title search fees, attorney fees, property insurance fees, points, credit agency fees, escrow fees and recording fees. Costs for these fees at closing will vary, but can be estimated at 2-5% of the total cost.
do you have a plot of land?
Finally, be sure you have a plan for the land that you’ll be building on as well. If you don’t already own the land, then you’ll need to include it in the construction loan. In most cases, it makes sense to pay for the land upfront if you’re able, to save yourself from a much larger down payment.
If you’re thinking of building your own home, you’ll want to make sure you take the time to lay the groundwork first. Start by meeting with a qualified lender, to understand your options, and find out what you’ll need to do to be approved. Then, make sure you find a qualified home builder, and work with them to create a detailed outline of your project. Finally, make sure you have enough money saved up for a down payment. As you can see it pays to do your research, and work with qualified professionals.
Sure, constructing a house requires commitment; however, you can always rely on BlueOx Credit Union for easy eligibility on home construction finance. Our trusted Mortgage Advisors treat you like a neighbor – not just a number – and provide local, hometown, superior service. For competitive interest rates, customized Home Loans to match your lifestyle, low closing costs, fast lending decisions and more, call us today at (269) 660-1310 and get started on building your dream home today!
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