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What is a construction loan?
A construction loan is a short-term loan used specifically for the building of a new home. A self-build loan is specialty financing distinct from a mortgage. Before getting permanent financing, the builder or buyer will get a construction loan to cover the closing costs of the construction project.
Home construction loans have historically had higher rates of interest than more traditional mortgage loans due to the higher perceived risk associated with them. Standard construction loans have a one-year term. In this time frame, you'll have to finish construction and get your Certificate of Occupancy. However, whether you're beginning from scratch or just updating your kitchen, there are a variety of new home construction loans to choose from. If you're beginning from scratch with a land loan or doing a thorough renovation, you may probably find a loan that suits your needs.
Finances from this loan can be spent on paying for preparing a construction plan, building materials, and the payment of salaries to employees engaged in construction. Also, construction loan funds can create a cash reserve in case the project turns out to be more expensive than the borrower planned or if the future homeowner does not want to pay interest during construction.
How construction loans work
First, the future homeowner applies for a construction loan, providing a detailed construction plan and a deadline for the project's readiness. After that, if the lender approves the loan application, the borrower can raise funds at each stage of construction. During the house construction process, the lender engages an independent appraiser or inspector who, after each stage of construction is ready, issues a permit for the sale of funds at the next stage of construction. Usually, after the construction is completed, the borrower needs to convert the construction loan into a traditional mortgage and begins to pay the principal amount of the loan. The borrower can pay interest both during construction and after converting the loan into a permanent mortgage.
Home construction loans usually have variable rates. This interest rate is usually higher than that of a traditional mortgage loan. In a traditional mortgage, real estate purchased by a bank acts as collateral for the borrower. In a construction loan, a built property is not collateral, so such a loan is riskier for a lender.
The initial term of the loan before conversion into a mortgage loan usually lasts as long as the construction. Because the term is so short, the borrower needs to provide the lender with clear construction deadlines, a detailed plan, and a realistic budget to get a loan.
Construction loan vs. mortgage
Construction loans are short-term. Most construction loans have a term of one year or less. The mortgage has a repayment term of 15, 20, or 30 years. Interest rates are typically indexed to a moving average, such as the LIBOR or Prime Rate, and hence are subject to change. Construction loan interest rates are higher than on conventional mortgages because the lender is taking on more of a financial risk. The approval procedure is also distinct from the standard mortgage industry norm. The construction loan provider will require thorough plans, a realistic schedule, and a reasonable budget.
Another key distinction between a construction loan and traditional mortgages is that repayment occurs in stages as the construction loans work is completed. Unlike a mortgage in which the borrower receives a lump sum at once in a construction loan, the disbursement of funds is carried out in stages by the construction plan. Moreover, to receive funds for the next stage, the borrower must pass an inspection from an inspector or appraiser who will confirm the implementation of the plan. Lenders in the construction industry keep a tight check on everything and will even send staff out to the site to verify that things are moving along well. The requirements for getting a regular mortgage, as opposed to a construction loan, are different. While conventional mortgages may just only be a few percent down these days, building loans often cause a much bigger down payment or equity.
A construction loan requires many documents and a large amount of down payment. The borrower must provide the lender with a detailed construction plan and make at least a 20% down payment. Sometimes, the borrower may use the value of the land for construction as a down payment.
Pros and cons of construction loans
Pros
A quick closure and flexibility. Usually, the closure of a construction loan occurs in 7-10 days. For example, closing a mortgage takes up to 60 days. Converting a construction loan into a mortgage allows the borrower to be qualified for 2 loans at a time. If the borrower submits documents for a construction loan and receives approval, then after the completion of construction, the conversion to a mortgage occurs automatically. Therefore, the borrower does not need to go through the application process and get approval for a mortgage.
Enhanced investigations. Lenders for this form of loan will want to see more detailed plans for how the money will be used. This is helpful since it ensures that your plans will be reviewed by a third party. As part of this procedure, you must provide the bank with a detailed building plan and timeline. Contractors owe it to you to give you clear, detailed information on the process they plan to use throughout construction, including the time frame, supplies, and personnel.
Adjustable payment schedule. Construction loans are more forgiving in terms and criteria than regular loans, but banks will still want detailed plans for your project. The flexibility of the loan conditions can be adjusted to meet the specific requirements of the project. During construction, interest-only payments are required. Since the bank will not get their money until the new building is finished, they will not require you to pay the principal until then. Paying solely interest on your mortgage loan during construction allows you to reduce your regular outgoings and put more money away. Some lenders may allow the borrower not to pay interest, even during the construction process. However, in this case, the borrower will have to pay a large amount of interest after converting the loan into a mortgage.
Options to pick from. Typically, purchasers settle for a home that comes "near enough" to their ideal design when searching the market for a new residence. The beauty of getting a construction loan is that you get to pick the builder and designer you want to work with to make your dream home a reality.
Change to a permanent loan. Due to improvements in the construction loan industry, an increasing number of borrowers can now take advantage of these opportunities. One of these advantages is the possibility of converting a construction loan into a permanent mortgage. A construction loan can offer the funds for a builder to complete a home and provide him with a repayment period.
Cons
Risky loan. There is a higher level of danger associated with construction-only loans. Never forget that the loan's full balance is due to the lender at the end of the loan term. You'd better be prepared to pay off the loan on your own in the event you are denied further financing.
Increased monthly payments. The beginning of your loan term will occur at the time you receive your loan, regardless of whether your term is 20, 25, or 30 years. You'll only have to pay interest for the first few months to a few years while the building is underway. When it comes time to actually repay the loan, though, the construction loan lender will factor in all the interest-only payments you made over the course of the loan's lifetime. This will increase your regular payments.
High interest. When making construction loans, lenders often add a premium on top of their prime rate (the rate they offer to their best clients), which means the interest rate on these loans can vary. The prime rate is the rate that lenders offer to their best customers.
Expensive construction costs. When purchasing a home that has already been constructed, the price you and the seller settle on is final. It can take months to create a house from scratch, and at that time, you might decide you don't want certain features after all. The price tag can go up with any sort of alteration. Subtle changes, such as those made to the floor tiles' pattern, can add up to several hundred dollars.
Strict eligibility criteria. It is difficult to qualify for a construction loan. To get a loan, the borrower must provide the lender with a detailed construction plan and clear deadlines for the completion of the project. Due to strict credit requirements, such a loan cannot be got by a novice loan builder without an excellent credit history.
Constant checks and additional fees. The inspector checks each stage of construction according to the plan provided by the borrower. The borrower may not receive funds for the next stage of construction if they have not fulfilled the plan. Some lenders may charge additional fees because the borrower does not finish the project on time.
Conclusion
If the borrower is planning to build real estate and has all the documentation to apply for a construction loan, then this loan option is a good choice. The process of getting an application approved is quite difficult, but a construction loan offers several advantages over other loans. The borrower needs to be prepared for frequent inspections and the appearance of additional fees and commissions.
Types of construction loans
Renovation loan
A renovation loan is a loan created to finance improvements to an existing home. Instead of starting from scratch, consider renovation construction loans choices if you want to improve an existing home. These can range from simple spreadsheets to complex databases, and their complexity is proportional to the amount of money you're willing to invest in the project.
If the borrower plans to spend less than $20,000 on repairs or installation of home improvements, then they should pay attention to a personal loan or credit card. For borrowers who plan to spend more than $25,000, a home equity loan or home equity line of credit is suitable. Renovation loans that are backed by the Federal Housing Administration are known as FHA 203(k) loans (FHA). Borrowers can use this to buy and improve a home with a single monthly payment.
Construction-to-permanent loan
You can finance the construction of your home with a construction-to-permanent loan, and then, once you've moved in, the loan will be refinanced as a conventional mortgage. The closing costs for a construction-to-permanent mortgage project are combined into one lump sum, which is a significant benefit.
During the construction process, the borrower pays only interest. The principal fee is divided into equal monthly payments for a standard mortgage term of 15 to 30 years.
Taking such a loan allows the borrower to save on payments for additional fees. Since the loan is converted automatically, the borrower doesn't pay closing costs for the construction loan and mortgage separately.
Young families who are building their first home can borrow money from an FHA construction-to-permanent loan. FHA construction-to-permanent loan has lax credit score requirements. Eligible veterans can get a VA construction loan that does not require a down payment and does not require payments on private mortgage insurance (PMI).
End loan
An end loan is just a traditional mortgage that the borrower takes out to pay the principal on a construction loan after construction is completed. You can use a construction loan during the building process and then pay it back once you're done. The borrower then has the final debt, or ordinary mortgage, to repay. Once the building is finished, you can apply for final traditional financing.
One benefit of an end loan is that a newly built home can be purchased with a mortgage application, just like any other property. When applying for a loan, the fewer hoops you have to jump through, the better.
Not all borrowers may be eligible for a construction-to-permanent loan. Also, some borrowers plan to pay off the lender in a different way but face financial problems after the completion of construction. Such borrowers qualify again for a mortgage or end loan.
Owner-builder construction loan
Loans for owners who simultaneously serve as builders are known as "owner-builder" loans. The difficulty of building a home and the experience needed to comply with building rules is why most construction loan lenders would not permit the borrower to act as the builder. That said, most construction lenders won't approve the loan unless the borrower is a professional builder with the appropriate licensing.
The owner-builder loan is a construction-only or construction-to-permanent loan in which future homeowners themselves act as builders.
Usually, lenders do not approve of such a loan because, to be a builder, the borrower must have the experience and qualifications. In a construction loan, the construction must go according to plan so the builder passes the check.
Construction-only loan
The borrower of a construction-only loan secures either the full amount due upon the loan's maturity, usually within a year or a mortgage in order to finance the home's ongoing maintenance and upkeep. Borrowers simply have to make interest payments on the cash received from construction loans, which are disbursed in proportion to the progress made on the project.
The construction-only loan covers the costs of the house construction process but with the condition that the borrower pays the entire amount issued by the bank immediately after the completion of construction. During the construction process, the borrower also pays only interest. After one year or a little more, depending on the duration of construction, the borrower either gives the principal amount in its entirety or takes out a mortgage.
This type of home loan costs the borrower more than any other. This loan is a higher-interest loan, as it is extremely risky for the lender. Since the borrower is likely to take out a permanent mortgage after the construction is completed, they will pay the settlement fee twice.
The borrower should also consider possible financial problems by the time the house is completed. If the borrower cannot be eligible for a mortgage due to financial problems, then they cannot pay the principal for a home construction loan.
How to apply for a construction loan?
Most home construction loans are structured to cover both the cost of the land on which the house will be built and the cost of building the home itself. So, if you're building a house, the first thing you'll do is apply for a construction loan. After you've located a suitable piece of property and settled on a reliable builder, it's time to schedule a meeting with your lender.
How to choose a lender
To choose the most suitable lender, the borrower should get as many loan offers as possible. To do this, they need to apply for pre-qualification from various banks or online lenders. After receiving the proposals, the borrower needs to compare what types of construction loans are offered by lenders. Loans such as owner-builder loans and construction-only loans may not be offered by all available lenders. The borrower should also pay attention to the availability and size of additional fees. Additional fees include settlement fees, origination fees, late fees, and prepayment penalties. Also, the borrower is recommended to choose a lender that offers the lowest interest rate among competitors. Another important aspect is the behavior of the lender in case of construction delays and failure to complete the process on time. The borrower needs to ask about this before signing the loan agreement.
Your prospective mortgage lender will want to see construction blueprints when you apply for the loan. They'll need to view your construction timetable and have at least a ballpark figure for how much money will be spent on supplies and labor. It's important to keep in mind that when applying for financing, lenders will want to see a thorough business plan. They need assurances that you have given this idea serious consideration and will see it through to fruition.
Eligibility criteria
To get a construction loan, the borrower must provide the lender with documentation confirming the amount of the project budget and the availability of a qualified builder.
You should expect queries from your lender regarding the contractor you plan to use. After all, the bank needs to communicate with the contractor you choose. They will inspect the work of your contractor regularly and pay them at the end of each stage of the project. Your debt-to-income ratio and credit history will be considered by the lender.
Construction loan lenders usually have strict requirements for borrowers. Most lenders require a minimum of 680 credit scores to obtain a construction loan. However, some lenders may require 720. The requirements are high because this loan is risky for the lender due to the lack of collateral.
The borrower must also have a stable, provable source of income. Different lenders require different minimum amounts of annual income. The borrower's debt-to-income ratio should not exceed 40%-45%.
There are mortgage companies that demand much higher down payments than others. Lenders typically need a down payment of 20%-30% of the entire cost of the construction project.
The application process
To apply for a home construction loan, the borrower needs to go to the lender's website and click on the "Get Started" or "Apply Now" button.
Here, the borrower needs to fill in information about himself, such as name, email, phone number, home address, and SSN. Enter data about employment status, employer's name and phone number, as well as the amount of his annual income and the amount of savings in the savings bank account. Next, the borrower needs to enter information about the future residential property, such as the area, the terms of readiness of the project, and data about the builder.
After filling in the data in the application form, the borrower may be asked to upload documents such as a contract with the builder, W-2s, pay stubs, and a detailed construction plan.
Ways to pay construction loans back
Any money you contribute to the entire transaction can count against your down payment. This includes the amount of money you provide. You will only be required to make payments toward the interest on the principal balance of the construction loan while you are in the construction phase. Your draw schedule and the total amount that it will cost to build the house will be used to calculate the amount of each of your interest-only monthly payments. This period, during which interest is solely charged, will continue until the completion of the building term.
In most cases, you won't have to pay interest on the full loan amount; instead, you'll just have to pay back the interest accrued so far on the money you've borrowed. Depending on the terms of your construction loan, you may or may not refinance it into a conventional mortgage once the building of your home is complete. If this is not an option for you, a mortgage, often known as an end loan, is another way to repay your construction loan.
In order not to overpay for an additional set of fees, such as closing costs, the borrower is recommended to pay attention to the construction-to-permanent loan. The borrower will not have to close the construction loan for an additional fee, and thus they can save several thousand dollars.
For quick repayment of the construction loan, the borrower should not refuse to pay interest during construction. If the borrower wants to make interest payments after converting the loan into a mortgage, then their monthly payments may be higher than expected.
The borrower should look for options for refinancing the loan after converting it into a permanent mortgage. Refinancing will allow the borrower to reduce the loan term and lower the interest rate, paying off the loan faster.