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 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 of them 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. The 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 loan providers 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
- Customization. The loans allow borrowers to build a custom home to their specifications, rather than having to choose from a limited selection of existing homes.
- Flexibility. With a construction loan, the borrower only has to pay interest on the loan during the construction process. This can reduce the monthly payment compared to other types of loans, such as traditional mortgages.
- Control. The borrower has control over the construction process and can make decisions about the materials and labor used to build their home.
Cons
- Complexity. Construction loans can be complex and difficult to understand, and may require a great deal of paperwork and documentation.
- Risk. Construction loans carry a higher level of risk than traditional mortgages, as there is no guarantee that the home will be completed as planned or that it will be completed on time.
- Cost. The loans often carry higher interest rates and fees than traditional mortgages, which can increase the overall cost of the loan.
- Timing. The length of time it takes to obtain a loan can be longer than other types of loans, as the lender needs to ensure that the construction is progressing as planned.
- Uncertainty. The loans can be unpredictable, as the cost of construction can often exceed the original estimate, leading to additional costs and a longer timeline for repayment.
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 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 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 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 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 loan.
How to Get a Construction Loan
Getting a construction loan is a process that requires planning, preparation, and patience. Before you start the process of obtaining a construction loan, it is important to understand the steps involved and what is required of you.
- Determine your budget. Before applying for a construction home loan, you need to determine your budget. This will include the cost of the land, construction costs, and any other expenses such as permits and inspections. You will also need to consider the cost of financing and interest rates, as well as any additional fees that may be associated with the loan.
- Choose the right construction loan lender. There are many lenders, including banks, credit unions, and other financial institutions. When choosing a lender, you should consider the interest rates and fees associated with the loan, as well as the lender's reputation and customer service record. You may also want to compare the different loan options available to determine which lender offers the best terms for your needs.
- Get pre-approved. Once you have determined your budget and chosen a lender, you will need to get pre-approved for the construction home loan. This will require you to provide the lender with financial information, including your credit score and income, to determine if you are eligible for a loan. You may also be required to provide a detailed construction plan, including specifications and drawings.
- Develop a construction plan. Before you can apply for a construction home loan, you need to develop a construction plan. This plan should include detailed specifications, drawings, and a timeline for the construction process. You will also need to provide a detailed budget, including all of the costs associated with the construction. The lender will use this information to determine if the loan is feasible and if the construction will be completed on time.
- Find a contractor. Once you have developed a construction plan and obtained pre-approval for a loan, you will need to find a contractor. The contractor will be responsible for the construction of the property, and you will need to provide the lender with the contractor's information, including their license and insurance information.
- Apply for the loan. Once you have gathered all of the required information, you can apply for the construction home loan. You will need to provide the lender with all of the necessary documentation, including your financial information, construction plan, and contractor information. The lender will then review your application and determine if you are eligible for the loan.
- Close the loan. If your loan is approved, you will need to attend a closing where the loan documents will be signed and the funds will be disbursed. At this time, you will also need to pay any closing costs associated with the loan.
Ways to Pay Construction Loans Back
Construction loans are designed to provide funding for the costs associated with the construction process, and are typically used when the borrower does not have the funds available to pay for the construction upfront. Once the construction is complete, the loan must be repaid in full. Here are several ways to pay back a construction mortgage:
- Traditional mortgage refinancing. Once the construction is complete, the borrower can apply for a traditional mortgage to refinance the construction mortgage. This option allows the borrower to pay off the construction mortgage with a longer-term mortgage, which typically has lower interest rates and more manageable monthly payments.
- Home equity line of credit (HELOC). A HELOC is a type of loan that allows the borrower to use the equity in their home as collateral. Once the construction is complete, the borrower can use a HELOC to pay off the home construction loan. This option provides the borrower with the flexibility to make payments as they are able, and can be a good choice for those who do not want to take on a large monthly payment.
- Personal loan. A personal loan can be used to pay off a construction mortgage. This option may be a good choice for those who have a good credit score and are able to secure a loan with a low interest rate. However, personal loans typically have shorter repayment terms, which can make the monthly payments higher.
- Cash. If the borrower has saved enough money to pay off the construction mortgage in full, they can do so with a lump sum payment. This option eliminates the need for monthly payments and can save the borrower money in interest charges over time.
- Sale of the property. If the borrower is unable to pay off the construction loan through other means, they can sell the property to repay the loan. This option is usually a last resort, as it requires the borrower to give up ownership of the property.
When considering the best option for paying back a construction home loan, it is important to take into account your financial situation, the interest rates and terms of each option, and your long-term financial goals. It is also recommended to consult with a financial professional to help you make the best decision for your unique situation.
Remember that construction loans typically are short-term loans and are typically only used to finance the construction of a new home or building. Once the construction is complete, the loan must be repaid in full. This means that it is important to have a plan in place for repaying the loan before you take it out, as failing to repay the loan can result in a loss of your property.
