Financing the construction of a home requires a different kind of mortgage than when you buy a new or older home. Here’s what you need to know about getting a construction loan.
What is a construction loan?
A home construction loan is a short-term, higher-interest loan that provides the funds required to build a residential property, explains Janet Bossi, senior vice president at OceanFirst Bank.
“These loans are usually one year in duration during which time the property must be built and a certificate of occupancy issued,” says Bossi.
A construction loan is used to cover the costs of work and materials for new-build homes. Some of the items you can finance with a construction loan include permits, contractor labor, home and roof framing costs, interior finishing costs and many of the other expenses involved in building a house, according to Rick Bechtel, head of U.S. residential lending for TD Bank.
Removable items, such as furnishings, can’t be included in home construction loans, Bechtel points out: “For instance, landscaping, trees and grass can all be included in a construction loan, but patio furniture cannot be.”
How do construction loans work?
Construction loans usually have variable rates that move up and down with the prime rate, according to Bossi. Construction loan rates are typically higher than traditional mortgage loan rates. With a traditional mortgage, your home acts as collateral — and if you default on your payments, the bank can seize your home. With a home construction loan, the bank doesn’t have that option, so they view these loans as bigger risks.
Because construction loans are on such a short timetable and they’re dependent on the completion of the project, you need to provide the lender with a construction timeline, detailed plans and a realistic budget.
Once approved, the borrower will be put on a bank draft or draw schedule that follows the project’s construction stages, and will typically be expected to make only interest payments during construction. Unlike personal loans that make a lump-sum payment, the lender pays out the money in stages as work on the new home progresses, says Bossi. Borrowers are typically only obligated to repay interest on any funds drawn to date until construction is completed.
While the home is being built, the lender has an appraiser or inspector check the house during the various stages of construction. If approved by the appraiser, the lender makes additional payments to the contractor, known as “draws.”
Depending on the type of construction loan, the borrower might be able to convert the construction loan to a traditional mortgage once the home is built, or they might be required to get a separate mortgage designed to pay off the construction loan.
Types of construction loans
Construction-to-permanent loans provide the funds to build the dwelling and your permanent mortgage as well, explains Bossi.
In other words, with a construction-to-permanent loan, you borrow money to pay for the cost of building your home, and once the house is complete and you move in, the loan is converted to a permanent mortgage.
The benefit of this approach is that you have only one set of closing costs to pay, reducing your overall fees, says Bossi.
“There’s a one-time closing so you don’t pay duplicate settlement fees,” says Bossi.
Once it becomes a permanent mortgage — typically with a loan term of 15 to 30 years — then you make payments that cover both interest and the principal. At that time, you can opt for a fixed-rate or adjustable-rate mortgage.
A construction-only loan provides the funds necessary to complete the building of the property, but the borrower is responsible for either paying the loan in full at maturity (typically one year or less) or obtaining a mortgage to secure permanent financing, says Bossi.
The funds from these construction loans are disbursed based upon the percentage of the project completed, and the borrower is only responsible for interest payments on the money drawn.
Construction loan rates are almost always tied to the prime rate plus a margin. Additionally, they might have a higher rate than traditional mortgages. Construction-only loans can ultimately be costlier if you will need a permanent mortgage because you complete two separate transactions and pay two sets of fees.
Another consideration is that your financial situation might worsen during the construction process. If you lose your job or face some other hardship, you might not be able to qualify for a mortgage later on — and might not be able to move into your new house.
If you want to upgrade an existing home rather than build one, you can look for a renovation loan, which comes in a variety of forms depending on the amount of money you’re spending on the project.
“The range of the loan size would dictate what the right product might be and what options may exist,” says Bechtel. “If you only need $10,000, you might opt for an unsecured (personal) loan, using a credit card or taking out a home equity line of credit (HELOC) against the existing equity in your home.”
However, Bechtel points out, as the dollar figure gets bigger, the more mortgage-like the product becomes.
The challenge with smaller projects that involve either unsecured loans or HELOCs, according to Bechtel, is that the review process is not as uniform or consistent as it is for a construction loan.
“With a construction loan, the bank is evaluating the builder as well as the customer to make sure the builder is a good credit risk,” says Bechtel. “There’s a clear, professional process in place.”
A renovation loan, on the other hand, particularly smaller loans, doesn’t require a budget being presented to the bank. Nor are draw schedules, plans and specifications required. The owner may just be writing a check upfront to a builder.
“In the construction loan world, the bank is to some degree managing the process, including the builder and the customer,” says Bechtel. “In the renovation space, the homeowner is managing the whole thing with the builder, and the bank is often not aware of what is occurring.”
Owner-builder construction loan
Owner-builder loans are construction or construction-only loans where the borrower also acts in the capacity of the home builder.
Most lenders won’t allow the borrower to act as their own builder because of the complexity of constructing a home and experience required to comply with building codes, says Bossi. Lenders that do typically only allow it if the borrower is a licensed builder by trade.
An end loan is another name for a mortgage, says Bechtel.
“There is a construction loan that’s roughly 12 to 18 months in duration and is purely for construction. When the house is done that loan gets repaid,” says Bechtel, “and then you need to go out and get an end loan, which is just a regular mortgage. It occurs after you have completed construction.”
Factors to consider about construction loans
Before you choose a construction loan, talk to your contractor and discuss the timeline of building the home and if other factors could slow down the job, such as inclement weather. Decide if you want to go through the loan process once or twice. Consider how much the closing costs and other fees of obtaining more than one loan will add to the project.
When getting a construction loan, you’re not just accounting for building the house; you also need to purchase the land and figure out how to handle the total cost later, perhaps with a permanent mortgage when the home is finished. In that case, a construction-to-permanent loan can make sense in order to avoid multiple transactions.
If you already have a home, though, you might be able to use the proceeds to pay down the loan. In that case, a stand-alone construction loan might be a better choice.
Carefully consider your needs and situation before moving forward.
How to get a home construction loan
At first glance, getting approval for a construction loan appears similar to the process of obtaining a mortgage. However, it does come with a few more requirements.
“Prior to making an application for a construction loan, a borrower should have met with an architect, had plans and specifications drawn and negotiated a contract with a builder reflecting the total cost to build so that a loan amount can be established,” explains Bossi.
Lenders review a borrowers’ employment history, savings, income stability and ability to repay the loan in addition to a thorough review of the plans and specifications. A property appraisal will also be obtained to support the value of the collateral, says Bossi.
To qualify, you’ll likely need:
How to find a home construction loan lender
“Because construction loans are more complex transactions than a standard mortgage, it is best to find a lender who specializes in construction lending and isn’t new to the process,” says Bossi.
Check several lenders to obtain details about their specific programs and procedures. Don’t forget to compare construction loan rates, terms and down payment requirements to ensure you’re getting the best possible deal.
If you have trouble finding a lender willing to work with you, check out smaller regional banks or credit unions. They might be more flexible in their underwriting if you can show that you’re a good risk, or, at the very least, have a connection they can refer you to.
Featured image by Chris Ryan of Getty Images.