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Mortgage

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.

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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.

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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Mortgage

How to Recover From Missed Mortgage Payments

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understanding good faith estimate vs loan estimate
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Can you bounce back from a missed mortgage payment or two? The answer is yes, but there’s work involved. After all, your payment history has the greatest impact in determining your credit score.

Falling behind on your mortgage payments can affect your credit and finances, and you could lose your home to foreclosure. It’s critical to be proactive and not wait until it’s too late to get help.

How missed mortgage payments affect your credit

In most cases, mortgage lenders give you a 15-day grace period before charging a fee — often around 5% of the principal and interest portion of your monthly payment — for late payments. But your credit history typically isn’t impacted until you’re at least 30 days behind on a mortgage payment. At this point, your mortgage servicer may report your late mortgage payment to the three major credit reporting bureaus: Equifax, Experian and TransUnion.

Your credit score could drop by 60 to 110 points after a late mortgage payment, depending on where your score started, according to FICO research. Being 90 days late on your loan could lower your score by another 20 points or more.

It can take up to three years to fully recover from a credit score drop after being a month behind on your mortgage, FICO’s research found. Once you’re three months behind on your mortgage, that time can increase to seven years.

Recovering from missed mortgage payments

Falling behind on your mortgage can be a frustrating and scary experience, particularly if you’re facing the threat of foreclosure. Here are some options to help you get back on track after missed mortgage payments:

  • Repayment plan. Your loan servicer agrees to let you spread out your late mortgage payments over the next several months to bring your loan current. When your upcoming payments are due, you’d also pay a portion of the past-due amount until you catch up.
  • Forbearance. Your servicer temporarily reduces or suspends your monthly mortgage payments for a set amount of time. Once the mortgage forbearance period ends, you’ll repay what’s owed by one of three ways: in a lump sum, a repayment plan or by modifying your loan.
  • Modification. A loan modification changes your loan’s original terms by extending your repayment term, lowering your mortgage interest rate or switching you from an adjustable-rate to a fixed-rate mortgage. The goal is to reduce your monthly payment to a more affordable amount.

Be proactive about getting back on track and reaching out to your lender for help instead of waiting until you get late payment notices. If you think you’ll be behind soon or are already a few days behind, make contact now and review your options.

Extra help for homeowners affected by COVID-19

If you’re behind on mortgage payments because of a financial hardship due to the coronavirus pandemic, you may qualify for a mortgage relief program through the Coronavirus Aid, Relief and Economic Security (CARES) Act.

Homeowners who have federally backed mortgages, and conventional loans owned by Fannie Mae or Freddie Mac, can request mortgage forbearance for up to 180 days. They can also request an extension for up to an additional 180 days.

Federally backed mortgages include loans insured by the:

  • Federal Housing Administration (FHA)
  • U.S. Department of Agriculture (USDA)
  • U.S. Department of Veterans Affairs (VA)

Reach out to your mortgage servicer to request forbearance. Even if your loan isn’t backed by a federal government entity, Fannie Mae or Freddie Mac, your servicer may offer payment relief options. You can find your servicer’s contact information on your most recent mortgage statement.

How many mortgage payments can you miss before foreclosure?

Your lender can begin the foreclosure process as soon as you’re two months behind on your mortgage, though it typically won’t start until you’re at least 120 days late, according to the Consumer Financial Protection Bureau. Still, it’s best to check your local foreclosure laws since they vary by state.

Here’s a timeline of how missed mortgage payments can lead to foreclosure.

30 days late

Your lender or servicer reports a late mortgage payment to the credit bureaus once you’re 30 days behind. Your servicer will also directly contact you no later than 36 days after you’re behind to discuss getting current.

45 days late

You’ll receive a notice of default that gives you a deadline — which must be at least 30 days after the notice date — to pay the past-due amount. If you miss that deadline, your servicer can demand that you repay your outstanding mortgage balance, plus interest, in full.

Your mortgage servicer will also assign a team member to work with you on foreclosure prevention options. This information will be communicated to you in writing.

60 days late

Once you’re 60 days late, expect more mortgage late fees, as you’ve missed two payments. Your servicer will send you another notice by the 36th day after the second missed payment. This same process applies for every month you’re behind.

90 days late

At 90 days late, your servicer may send you a letter telling you to bring your mortgage current within 30 days, or face foreclosure. You’ll likely be charged a third late fee.

120 days late

The foreclosure process typically begins after the 120th day you’re behind. If you live in a state with judicial foreclosures, your loan servicer’s attorney will file a foreclosure lawsuit with your county court to resell the home and recoup the money you owe. The process may speed up in nonjudicial foreclosure states, because your lender doesn’t have to sue to repossess your home.

You’re notified in writing about the sale and given a move-out deadline. There’s still a chance you can keep your home if you pay the amount owed, along with any applicable legal fees, before the foreclosure sale date.

Can you get late mortgage payment forgiveness?

If you’ve otherwise had a good payment history but now have one missed mortgage payment, you could try writing a goodwill adjustment letter to request that your servicer erase the late payment information from your credit reports.

Your letter should include:

  • Your name
  • Your account number
  • Your contact information
  • A callout of your good payment history prior to missing a payment
  • An explanation of what led to the late mortgage payment
  • The steps you’re taking to prevent late payments in the future

End the letter by requesting that your servicer remove the late payment from your credit reports, and thank your servicer for their consideration. Print, sign and mail your letter to your servicer’s address.

The letter is simply a request; your servicer isn’t required to grant late mortgage payment forgiveness. If your servicer agrees to remove the late payment info from your credit reports, your credit scores may eventually increase — so long as you continue to make on-time payments.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

By clicking “See Rates”, you will be directed to LendingTree. Based on your creditworthiness, you may be matched with up to five different lenders in our partner network.

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Mortgage

What Is the Minimum Credit Score for a Home Loan?

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If you’re hoping to become a homeowner, your credit score may hold the keys to realizing that dream. Knowing the minimum credit score needed for a home loan gives you a baseline to help decide if it’s time to apply for a mortgage, or take some steps to boost your credit first.

It’s possible to get a mortgage with a score as low as 500 if you can come up with a 10% down payment. Keep reading to learn the minimum credit score requirements for the most common loan programs.

What are the minimum credit scores for home loans?

Your credit score plays a big role in determining whether you qualify for a mortgage and what your interest rate offers will be. A higher credit score means you’ll likely get a lower rate and a lower monthly mortgage payment.

There are four main types of mortgages: conventional loans, and government-backed loans insured by the Federal Housing Administration (FHA), the U.S. Department of Veterans Affairs (VA) and the U.S. Department of Agriculture (USDA). Conventional loans, which are the most common loan type with guidelines set by Fannie Mae and Freddie Mac, have a credit score minimum of 620. Although some loan programs don’t specify a minimum credit score needed to qualify, the approved lenders who offer them may set their own minimum requirements.

The table below features the minimum credit scores for these home loans, along with minimum down payment amounts and for whom each of the loans is best.

Loan type

Minimum credit score

Minimum down payment

Who it’s best for

Conventional6203%Borrowers with good credit
FHA500-579 with 10% down payment
580 with 3.5% down payment
10% with a score of 500-579
3.5% with a minimum score of 580
Borrowers who have bad credit and are purchasing a home at or below their area FHA loan limits
VANo credit minimum, but 620 recommendedNo down payment requiredActive-duty service members, veterans and eligible spouses with VA entitlement
USDA640No down payment requiredBorrowers in USDA-eligible rural areas with low- to moderate-incomes

What is a good credit score to buy a house?

Meeting the minimum score requirement for a home loan will limit your mortgage options, while higher credit scores will open the doors to more attractive rates and loan terms. A good credit score can also provide you with more choices for home loan financing.

  • 740 credit score. You’ll typically get your best interest rates for a conventional mortgage with a 740 (or higher) credit score. If you make less than a 20% down payment, you’ll pay for private mortgage insurance (PMI). PMI protects the lender in case you default on your home loan.
  • 640 credit score. Rural homebuyers need to pay attention to this benchmark for USDA financing. Exceptions may be possible with proof that the new payment is lower than what you’re paying for rent now.
  • 620 credit score. The bare minimum credit score for conventional financing comes with the largest mark-ups for interest rates and PMI.
  • 580 credit score. This is the bottom line to be considered for an FHA loan with a 3.5% down payment.
  • 500 credit score. This is the lowest credit score you can have to qualify for an FHA loan, but you must put 10% down to qualify.

Annual percentage rates by credit score

Your mortgage rate is a reflection of the risk lenders take when they offer you a loan. Lenders provide lower rates to borrowers who are the most likely to repay a mortgage.

Here’s a glimpse of the annual percentage rates (APRs) and monthly payments lenders may offer to borrowers at different credit score tiers on a $300,000, 30-year fixed loan. APR measures the total cost of borrowing, including the loan’s interest rate and fees.

FICO Score

APR

Monthly Payment

760-8503.011%$1,267
700-7593.233%$1,303
680-6993.410%$1,332
660-6793.624%$1,368
640-6594.054%$1,442
620-6394.6%$1,538
*Based on national average rate data from myFICO.com for a $300,000, 30-year, fixed-rate loan as of May 4, 2020.

As the credit score ranges fall, the interest rates are higher. Borrowers with a score of 760 to 850, the highest range, saw an average monthly payment of $1,267. Borrowers in the lowest credit score tier of 620 to 639 saw their monthly payment jump to $1,538. The extra $271 in monthly payments adds up to an additional $97,560 in interest charges over the life of the loan.

Steps for improving your credit score

Now that you have an idea of the extra cost of getting a minimum credit score mortgage, follow some of these tips that may help boost your score.

  • Make payments on time. It may seem obvious, but recent late payments on credit accounts hit your scores the hardest. Set your bills on autopay if possible to avoid forgetting to pay one.
  • Pay off balances monthly. Try to pay your entire balance off each month to show you can manage debt responsibly.
  • Keep your credit card balances low. If you do carry a credit card balance, charge 30% or less of the available credit limit on each account.
  • Have a mix of different credit types. Mortgage lenders want to see you can handle longer-term debt as well as credit cards. A car loan or personal loan will help demonstrate your ability to budget for installment debt payments over time.
  • Avoid applying for new accounts. A credit inquiry tells your lender you applied for credit. Even if you were applying to get your best deal on a credit card or car loan, multiple inquiries could drop your scores, and give a lender the impression you’re racking up debt.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.