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Understanding Real Estate Construction Loans

To build a new house is a dream shared by many Americans. Many people might never act on it, while many others certainly will: finding ways to save and plan, and one day build the home they always wanted.

The good news is that if you are looking for help in achieving a similar dream, there are programs and loans that are ready to help you. The complication is that real estate construction loans are more complicated than a normal loan, so you have to do a little more legwork.

This article will help you to understand some of the basics about new construction real estate loans so that you can one day also claim your own part of the American dream.

What are Real Estate Construction Loans?

Before delving into the specifics of loan types and how they might work for you, there are some commonalities shared by all real estate construction loans, including:

  • banks – while mortgage companies might be most common with securing a conventional mortgage, they tend to shy away from the complexity and risk of real estate construction loans. Banks are where you need to concentrate your efforts seeking this kind of financing, most often, as well as some government programs;
  • land – usually, the property on which you will be building is included in the real estate construction loan. It is not required though. If you own property already, you actually may be able to leverage it as collateral, and get better terms for your construction loan;
  • plans – you will need to provide detailed plans and timetables to qualify for this type of financing. Expect much more scrutiny, supervision and direct activity with your lender;
  • FICO – as a real estate construction loan is often lacking a home as collateral, the borrower’s FICO score is much more important than it might be in other financing.

Most often, construction loans are short-term loans (one year or less) that turn into a longer, more conventional mortgage when building is complete. The larger part is usually 15 or 30 years.

With a construction loan secured, you will receive installment payments for that first year of building. They are on a predetermined draw schedule to cover the costs of building. You will make interest-only payments during the building period, typically based on a variable rate.

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Expect your lender to check-in every time before disbursing draw-period funds, to make sure the project is adhering to the schedule pre-approved by you, the builder and the lender. Everything works off schedules and milestones that you had clearly set out to the lender to secure financing.

How the loan works more specifically depends on the type on loan you secure, and who you secure it with.

Types of Real Estate Construction Loans

There are two types of real estate construction loan: a stand-alone construction loan, and a construction-to-permanent loan. Though sharing the commonalities already mentioned, they differ in the benefits they could present to you, as a borrower.

  • Stand-alone construction loans: the name of this loan is a little confusing, as it WILL include a longer-term mortgage as well. But the unique trait here, is the construction loan is handled as a separate loan to the mortgage that follows – the lender uses the first loan, to get you locked into securing the larger second one. You will usually have two sets of closing (and associated costs) with this loan type – at the beginning, and then again as you refinance the larger mortgage. The interest rate is variable during the build period and becomes fixed for the mortgage part of it. The payments made during the build are interest-only, and then you settle your balance as you roll the principal into your 30-year, fixed-rate mortgage.
  • Construction-to-permanent loans: a more common type of real estate loan, this one will combine the two loans (build, mortgage) into one 30-year loan at a fixed rate. This loan type will usually require more of the borrower, in terms of down payments and credit scores. The clear benefit it has over the other, is the single set of closing costs to get the full loan amount, and an ability to fix the interest rate earlier.

One benefit of the stand-alone loan is for people who already own a property and may be looking to sell it when their build is completed. The stand-alone would allow this borrower to put more money down once they sell their existing home – which they could not do with the other loan type.

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The stand-alone could also help people who have less money up-front to get into their property, because they could use the finished home as collateral to secure a better rate for the mortgage.

Another strategy is to look to the government for any existing programs that might be applicable to your situation.

FHA and VA Options for Construction Loans

The US Department of Housing and Urban Development (HUD) uses FHA loans to help more buyers find homes. Boasting low down payments and closing costs with easy credit qualifying, these loans can bring opportunity to a wider range of applicants. These traits hold true in FHA real estate construction loans.

FHA construction loans are construction-to-permanent, meaning only one closing. Key benefits of this loan, compared to one you would secure at a bank, include:

  • A higher DTI (debt-to-income) level may be allowed;
  • Reduced down payments, even as low as 3.5%;
  • Federally-insured program with specific advisors and resources.

An FHA construction loan will have a few more stipulations as well, such as land ownership involved in the deal. If you owned the land for more than six months, you cannot qualify for this loan.

Your city will also need to provide a certificate of occupancy following a detailed inspection of the property after the building period. 60 days after this is issued, your loan begins amortizing.

Veteran Options

US military veterans might have additional options to consider. Though the VA does not itself offer any loans, some qualified VA lenders will offer VA construction loans.

The good news is that qualifying for them uses the same criteria as any VA home loan. The challenge, however, is in finding a VA lender who offers them: they are often considered too risky, so they are not common in the marketplace.

Once you do find a VA construction loan provider, you are going to need to adhere to a very strict set of guidelines and rules about the property and the finished building to meet VA regulations and property requirements. They take an average of 45-60 days to close, which is a long time for any type of mortgage.

The benefits of the VA construction loan, which is a construction-to-permanent type, include:

  • Potentially getting into the loan with low, or even zero money down;
  • Gentle credit requirements;
  • No PMI (private mortgage insurance) and low interest rates.
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The real challenge in securing a VA construction loan, is finding a lender and a builder who are both comfortable with the deal. The risks, extra paperwork and delays involved make these loans more of a true rarity in the current marketplace…but veterans can certainly benefit from the extra efforts made to find and secure them.

Realizing the Dream

If building your own home is a dream held, you should be happy that there are loan programs designed specifically to help you achieve that goal.

You should expect to put in some extra footwork to find a lender offering your loan, as well as saving for a larger down payment typically required. You’ll want to be building your credit score too, as it will play a larger role in your qualification.

If you are not a licensed contractor yourself, you will want to find a builder to work with who understands your funding needs. You will need plans and schedules to submit for funding, and you will have multiple checkpoints during construction to keep everything on-track.

You will receive money during the draw period, during which you are paying only interest on your loan. Following the build, you will have a 15- or 30-year mortgage at a fixed rate and pay either one or two sets of closing costs to get there, depending on your loan type.

As you can see, despite their complexity, construction real estate loans do provide opportunity and potential for many prospective homebuyers. While they may not be as popular and common as other types of mortgages, they can certainly be the key in helping you achieve your own dream home.

Homeowners May Want to Refinance While Rates Are Low

US 10-year Treasury rates have recently fallen to all-time record lows due to the spread of coronavirus driving a risk off sentiment, with other financial rates falling in tandem. Homeowners who buy or refinance at today’s low rates may benefit from recent rate volatility.

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