everything you need to know about construction loans

With a shortage of homes for sale on the market, you may be looking to build your new dream home. Building your own home can be a tremendously rewarding experience. You get to make choices about everything from location and floor plan to colors and landscaping. At the end of the process, you have a truly special place to live, something uniquely yours. But how do you pay for it? And how do new construction loans work?

While a project like building your home can be both exciting and fun, there are many things to consider before you begin building. Probably the most important consideration is how this type of project gets paid for.

what is a construction loan?

A home construction loan gives you the funds needed to build a house on a piece of land, typically for one year, during the construction period. Construction loans are used to cover all sorts of things that go into building a home: land, labor, permits, and building materials.

Depending on the lender you choose, there can be different requirements you'll need to meet or limitations that you might find with the loan. For example, a construction loan doesn't usually cover the home furnishing aspect of a home, although it may cover things like permanent fixtures throughout the walls of the interior and necessary appliances, such as fridges and washing machines.

Home construction loans are used when you have purchased a piece of land and are ready to build. A land loan is often used when you want to buy land but aren't quite ready to construct your dream home.

the construction loan process

Unless you have the cash on hand to fund your construction project, you're going to need a construction loan in order to finance the cost of the building project –and sometimes the purchase of the land itself.

A construction loan is a short-term loan that covers the cost of construction until the home is complete, and a traditional mortgage can be taken out. New construction financing differs from resale finance because the home itself doesn’t exist. This means if the payments stop and the lender needs to foreclose, they must finish constructing the house first. Naturally, this makes construction loans riskier and lenders more wary.

If you’re on the fence about building your own home – and curious about funding options, here’s a look at what you should know about new home construction loans.

types of construction loans

Construction Loans are usually short-term higher interest loans that last until the home is completed. In most cases, the lender pays the funds directly to the contractor rather than the borrower. These payments – also known as draws – often come in installments at different stages of development rather than all at once.

Now, let’s get more specific and look at some of the different types of custom home financing that are available today.

construction only loan

Buyers who choose a construction-only loan are usually looking for the best deal possible on a permanent loan. With this loan, the lender will typically offer enough money to cover the cost of the project, and the borrower will usually make interest-only payments until it’s complete. The principal balance is commonly due in full once the project is complete or one year later. This allows the borrower the freedom to apply for a mortgage once the project is complete. If the buyer chooses this route, make sure you know what to ask your lender before choosing a loan product.

construction-to-permanent loan

Construction-to-permanent loans are very popular with homebuyers. With this type of loan, the buyer takes out a loan from the lender that’s essentially a line of credit, and the builder can draw from it at each stage of construction. There are on-site inspections at the various draw stages. At the end of the draw period, the construction loan converts into a permanent amortized loan.

The construction-to-permanent mortgage loan usually covers the cost of the construction project and the mortgage on the completed property. An interest-only payment during the construction period is typical with this type of loan. There's only one closing with this type of loan because the borrower will be working with the same lender for the construction and the mortgage loan. The interest rate is usually the same for both loans, and there may be a penalty if construction exceeds one year.

The single-close loan eliminates a second set of closing costs. This loan requires only one application, and once it’s approved, there's no secondary approval process required.

VA and FHA construction loans

There are VA and FHA construction loans available as well. However, these loans can be difficult to qualify for and may be hard to use because of loan limits. At the end of construction, you’ll usually move into what’s known as permanent financing. At this point, you’ll also have the option to pay off the loan or convert it into a traditional home mortgage.

what are the requirements for a construction loan?

In order to be approved for a construction loan, there are some terms and conditions that need to be met. Each lender will have different criteria that the borrower will need to meet; as a self-build loan is much riskier than traditional mortgages, the standards can be strict. As always, make sure you speak with a lender before you begin to see what they specifically require for you to qualify.

Generally, though, they’ll want to see the following items:

qualified builder

First up, the lender will want to see that you’re working with a qualified builder. This means a construction company or a licensed general contractor who has a solid reputation for building quality homes. If you’re planning on being your own general contractor, you may have a difficult time being approved for a home construction loan.

detailed specifications

Next, it’s not enough to simply request a loan – you’ll need to provide the lender with detailed plans and specifications, including everything from materials that will be used – such as insulation and roofing, as well as ceiling heights and room dimensions. These plans should be professional architectural drawings.

value estimated by an appraiser

The value of the home will be assessed by a licensed appraiser. The appraised value will be based on the plans and specifications and the value of the lot. These calculations will then be compared with comparable homes in a similar location.

proof of income

Be prepared to provide proof of income in the form of W2s and pay stubs; or tax returns, profit/loss, and balance sheet if you’re self-employed.

down payment

Lenders will also want to make sure that the loan-to-value (LTV) isn’t more than 90%, including the value of the land. Many lenders won't disperse more than 80% of the value prior to the completion of construction.

healthy credit score

You’ll also need a good credit score. A score of at least 660 will generally be required.

what does the lender need from the builder?

In addition to the criteria you’ll need to meet as the buyer, here are some things the lender will need to see from the builder as well:
 

• Project description
• Plans
• Specifications
• Building license
• Proof of Insurance
• Banking information, profit, and loss statement
• Budget for project
• Signed contract with the buyer
• Job cost
• Timeline

construction loan calculator

Just like with conventional mortgages, you can find numerous construction loan calculators online. From simple to complex, there are many options out there for you to work with. Or you can reach out to your construction mortgage lender, who will help you calculate the conversion of the loan from construction to a traditional mortgage and will provide you with the monthly principal and interest payments on that portion of the loan as well. To get a final number, you'll need to know the following information:
 

• Price of the lot/property
• Cost of construction
• Duration of the project
• Approximate appraised home value of the completed home
• Estimated interest rate on the loan

construction loan closing costs

Just like with purchasing an existing home, many new home buyers are surprised by the closing costs. Closing costs for new construction include fees for items like origination fees, home inspection fees, home appraisal fees, title search fees, attorney fees, property insurance fees, points, credit agency fees, escrow fees, and recording fees. Costs for these fees at closing will vary but can be estimated at 2-5% of the total cost.

do you have a plot of land?

Finally, be sure you have a plan for the land that you’ll be building on as well. If you don’t already own the land, then you’ll need to include it in the construction loan. In most cases, it makes sense to pay for the land upfront, if you’re able, to save yourself from a much larger down payment.

If you’re thinking of building your own home, you’ll want to make sure you take the time to lay the groundwork first. Start by meeting with a qualified lender to understand your options and find out what you’ll need to do to be approved. Then, make sure you find a qualified home builder and work with them to create a detailed outline of your project. Finally, make sure you have enough money saved up for a down payment. As you can see, it pays to do your research and work with qualified professionals.