Understanding Construction Loans

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Mortgages are typically easy to find. But most home loans are only available for houses that already exist. If you need financing to build a home, a construction loan can help you cover the costs of buying land and building the home of your dreams.

Construction loans bear some resemblance to traditional mortgages, but the process of applying is different in many ways. After all, the loan’s collateral doesn’t exist yet.

What is a construction loan?

A construction loan is usually a short-term loan used to pay for the cost of building or remodeling a home.

With a traditional mortgage, the lender pays out the full amount of the mortgage to the seller upon closing. But a construction loan is typically paid out to the homebuilder in a series of advances as the project progresses. For example, the lender may disburse a portion of the funding once the foundation is poured, another portion after framing is completed, etc.

During construction, you typically make interest-only payments based on the funds that have been disbursed, although some construction loans do not require payments until the project is complete. At that time, you will need to either pay off the balance of the loan in a lump sum, convert your construction loan into a traditional mortgage or apply for a new loan.

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Types of construction loans

What happens to your construction loan once the project is complete depends on whether you have a one-time close loan or a two-time close loan.

One-time close

One-time close construction loans, also known as “all-in-one loans” or “construction-to-permanent loans,” wrap the loans for construction and the mortgage on the completed home into a single loan. Once your home is complete, the construction loan converts to a regular mortgage. There is no additional approval process or closing costs.

The downside of a one-time close construction loan is that construction projects tend to run over budget. If your project goes over budget, you’ll need to come up with the difference out of pocket or take out a second loan to cover the overages. For that reason, unless you have a solid grasp of the costs and schedule for the project, a one-time construction loan may not be right for your project.

Two-time close

A two-time close construction loan is two separate loans — a short-term loan for the construction phase and a long-term mortgage for the completed home. Essentially, you will refinance your construction loan once the project is complete.

A two-time close construction loan can be more costly because you need to go through the approval process and pay closing costs twice. But you’ll have more flexibility in the loan amount if your project goes over budget.

How construction loans work

Getting a construction loan requires a little more red tape than getting a traditional mortgage. Here’s a step-by-step walk through the process.

1. Get your finances in order

The qualifications for a construction loan will vary from lender to lender. As with any loan, the higher your credit score and the stronger your financial situation is, the more options you’ll have.

Fannie Mae, one of the leading sources of financing for mortgage lenders, requires a minimum credit score of 620 and a maximum debt-to-income ratio of 45%.

Adham Sbeih, CEO and founder of Socotra Capital, a real estate lending and investment firm based in Sacramento, Calif., said borrowers need to demonstrate an ability to handle the monthly payments and handle potential change orders and cost overruns. “Borrowers also need to show they have a viable exit strategy for completing construction,” he said. “After all, construction loans are temporary.”

2. Meet with a lender to get preapproved

Once you have your finances in order, it’s time to meet with a lender to find out how much you can borrow.

The lender will look at your debt, income and asset information. The amount the lender preapproves you for will be an essential part of your discussions with your builder in deciding what to include in your new home. The lender can also answer any questions you have about how construction loans are structured.

3. Create your wish list

Create a wish list and ideas of what you want your home to look like. Keep in mind that you may have to compromise on some of these items if your wish list is larger than your budget.

4. Find a builder

Look for a reputable, experienced builder. Before approving your loan, your lender will review your contractor’s experience, reputation, credit and licenses to ensure your contractor can get the job done on time and within budget.

The builder will put together detailed specifications, including floor plans, a materials list, a line-item budget and a draw schedule. This is sometimes called a “blue book.”

5. Apply for the loan

Once you have a signed construction or purchase contract with your builder, it’s time to complete the application process for your loan. The lender will perform a more thorough review of your finances, review your contractor and the building specifications in detail. They will likely also have an appraiser review the specs of the house and the value of the land to come up with an appraised value for the finished project.

6. Purchase the land

If you don’t already own the land on which you plan to build a home, you’ll need to purchase it. A construction loan can include financing for the purchase of a lot. Your lender will ask for a copy of the contract to purchase the land as part of the loan application.
If you already own the land and have an outstanding loan on the property, the first disbursement of your construction loan will pay off that loan before construction starts on the home.

7. Build the home

Once your loan closes and you’ve purchased your land, construction can begin. Your lender will continue to monitor the progress of the project, pay the builder according to the draw schedule and send an inspector to the property on a regular basis to ensure the project is proceeding as planned.

Sbeih said the two big potential pitfalls borrowers run into during this phase are time and budget. “If construction is delayed and takes longer, the borrower pays interest on the construction funds for a longer period of time, which costs more,” he said. “The more dangerous concerns are change orders and budgets that are not rock-solid. If you do not have a solid budget [that] includes padding for contingencies, you are flirting with disaster. This is how you end up with a project that is 80% complete and has no funding to make it to the finish line.”

8. Transition to a permanent loan

When the home is complete, you will transition to a permanent loan. If you have a one-time close loan, this process is automatic. If you have a two-time close loan, you will need to reapply and pay closing costs on a new loan.
Keep in mind that if you have a two-time close loan, you will need to go through the approval process again to transition to a permanent loan. If your income, credit or financial situation change for the worse during the construction phase, you may be unable to get a mortgage on the completed home and could end up losing the house to foreclosure before you even have a chance to move in.

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What it takes to get approved for a construction loan

The approval process and documentation required for a construction loan vary by lender, but the following list should give you a good idea of what you’ll need.

Documentation

  • If you own the land, you’ll need to show a copy of the deed to the land and the settlement statement for the purchase if you bought it within 12 months of applying for the loan
  • A copy of the contract to purchase the land if you don’t already own it
  • Your contract with the builder
  • Complete information on your builder, including name, address, phone number, etc.
  • Building plans and specifications
  • Proof of insurance from the builder
  • Proof of insurance covering the project
  • Documentation of your income, such as W-2s, tax returns and pay stubs
  • Authorization to perform a credit check
  • Information on your debts so the lender can calculate your debt-to-income ratio

Down payment

Lenders typically require a down payment of 20% to 25% of the appraised value of the home, at a minimum. This ensures you are invested in the project and are less likely to default on the loan or walk away if the project runs into issues.

If you already own the land on which you’ll build, the value of the land can be included in that equity contribution.

Cash reserves

Conventional loans require a borrower to have cash reserves of anywhere from two to 12 months’ worth of mortgage payments. You’ll likely need more for a construction loan because you’ll have to make payments on your construction loan during the building phase, as well as make rent or mortgage payments on your existing home.

Construction Loan vs. Traditional Home Loan

 

Construction loan

Traditional home loan

Down payment

A down payment of 20% to 25% is the norm

You may be able to get a loan with no down payment or only 3% down

Interest rates

Typically variable interest rates during the construction phase. Higher than traditional mortgage rates.

May be fixed or variable

How the loan is disbursed

Paid out in draws to the builder at predetermined project milestones

Paid in full to the seller at closing

Documents required

All the documentation necessary for a traditional home loan, plus information on the builder and detailed building specifications for the project

Requires documentation on borrowers’ finances and appraisal of the property

Term

Typically one year

15- or 30-year terms are most common

Credit required

Excellent credit

Borrowers with credit scores as low as 500 may be able to get approval

Closing

Takes 7-10 days longer than a traditional mortgage

1½ months, on average

Monthly payments

Usually interest-only during construction

May be interest-only or interest plus principal

Where to find a construction loan

Talk to your bank to begin the process of applying and qualifying for a construction loan. Most construction loans are issued by banks rather than mortgage companies, as the bank will hold on to the loan until the project is complete.

Not all banks offer construction loans. Among those that do, interest rates, terms and fees can vary widely. So it’s a good idea to talk to a few different banks to make sure you’re getting the best deal.

Is a construction loan right for you?

Few homebuyers would be able to build a home to their exact specifications if it weren’t for construction loans. But a desire to design your own dream home isn’t the sole factor to consider when deciding whether a construction loan is right for you. They have stricter underwriting requirements, require larger down payments and have higher fees because of the ongoing inspections required during the construction phase.

If you have excellent credit, can afford a substantial down payment and have an adequate financial cushion to see you through unexpected delays and cost overruns, a construction loan can finance building your dream home. But if your financial footing isn’t as solid, you’re probably better off buying a home that’s already been built — or waiting until you can afford to weather the risks and uncertainties inherent in building.

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Janet Berry-Johnson
Janet Berry-Johnson |

Janet Berry-Johnson is a writer at MagnifyMoney. You can email Janet here