Construction Loan: Read This Before You Borrow!
Are you dreaming of constructing a custom home? That’s great because you’ll have everything made to your exact specifications. If you’re not financing the building with your savings, you should consider getting a construction loan. Everything you need to know before borrowing them is covered here:
What Is a Construction Loan?
It’s a loan product that finances the construction of a new house by a builder. Don’t expect to have funds deposited in your account, so you can pay for material costs, labor, etc. The lender will work with your chosen builder directly. Funds are disbursed through a series of draws until the house is built.
“How will the lender know how much cash I need?”
Well, it’s the contractor’s role to supply all the information about the project. They must state all the costs and outline the project timelines.
Now, all the ways you can use construction loans include:
- Building on land you already own.
- Constructing a home on a newly acquired lot.
- Setting up a house on gifted land.
- Paying off an outstanding land loan before setting up the house.
- Prefab home financing.
- Paying for remodeling costs after refinancing an existing mortgage loan.
How Do Construction Loans Work?
There are two types of construction loans, and here is how each works:
1) Pure Construction Loan
It’s meant to pay for land acquisition and home construction. To understand it better, realize that there are two loan periods when building a house with outside financing:
Stage 1: Home Construction
Pure construction loans cater for costs incurred during the construction period that lasts for up to 12 months. You don’t have to borrow a separate loan to by the land.
As the builder builds on your lot, the lender will expect interest-only payments. Following the project completion, the lender expects you to pay the full loan principal and any outstanding interest.
Stage 2: Getting a Permanent Loan
“Where will the funds for paying off the first construction loan come from?”
Well, you just borrow a permanent or normal mortgage loan. The new construction loan allows you to refinance the original loan. Afterward, you start paying interest and principal payments each month.
Downsides to Pure Construction Loans
Taking out two loans has challenges:
a) Two Sets of Closing Costs
You pay closing costs for the construction and permanent loan. But if you incur one set of costs, you might save hundreds of dollars.
b) Two Applications
Expect to spend more time finding another lender to refinance your loan.
2) Construction to Permanent Loans
These loans are also called:
- Single close loans
- Combination loans
- One-time loans
- Construction perm loan.
Construction to permanent financing is simpler and less time-consuming than the first option. There is one loan period, and one loan will take you from the start to the finish of the project. The construction loan will automatically convert to a permanent mortgage loan.
Why Is This Significant?
- Incur one set of closing costs.
- Pay interest-only payments during the construction phase.
- The interest payments amounts increase as your builder makes more draws. For instance, if the builder is making equal draws of $10,000, after the first withdrawal you’ll be paying interest for $10,000. Following the second draw, you start paying interest for $20,000 and so forth.
Construction Loan Rates
Banks structure construction to permanent loan rates in two ways:
1) 5, 7, 10-Year Adjustable-Rate Mortgage
With this option, the interest rate for the permanent loan will be adjusted after periods of 5, 7 or 10 years. Your revised rate might be higher or lower depending on the prevailing market construction loan rates.
2) 15 or 30-Year Fixed-Rate Loans
The interest rate is fixed for the entire loan duration. Common amortization periods are 15 or 30 years. Some fixed interest loans come with one chance to adjust the rate before it converts to a perm loan. For instance, if you notice that the market construction loan interest rates have fallen during the construction phase, you can ask the lender to revise your fixed rate.
What are the current construction loan rates?
They typically range from 4% to 6.50%.
Construction Loan Requirements
Some of the basic requirements include:
1) Having Credit Scores of 680+
Good credit scores will increase your chances of obtaining loans from construction lenders. Borrowers with the highest scores receive lower construction loans rates of interests and might pay lower down payments because they are more creditworthy.
2) Proof of Income
The lender will want to know your annual and monthly income. That’s because your income supports the interest-only payments and subsequent payments after loan conversion. You’ll have to submit documents that prove your actual earnings such as tax returns, pay stubs, bank account statements, etc.
3) Low Debt-to-Income Ratio
Qualifying for traditional loans is difficult if you have many open credit accounts. You can qualify for new credit as long as your debt-to-income ratio is not more than 45%. Some banks require a lower DTI ratio of 30%.
You need cash set aside for the downpayment on the new construction loans. It ranges from 20% to 30% of the total loan amount.
Why Do Lenders Ask for a Large Downpayment?
Before your house is built, the loan is not secured with good collateral. Therefore, the lender is incurring more risk. Remember that construction projects have lots of moving parts and might not go exactly as planned.
Requirements to Be Fulfilled by the Builder
The bank also expects builders to supply structural drawings, architectural drawings, electrical drawings, cost breakdown sheet, etc. These documents help the bank’s chosen appraiser to assess the value of the building before it’s complete.
The builder also has to provide the draw schedule. It specifies the stages at which the builder will ask for funds to be released and the work that will be so far completed. Lenders work with third-party inspection services before authorizing draws.
Construction Loan Process
Understanding the process of obtaining construction loans from banks helps you to fully answer the question of “How do construction loans work?”
1) Finding a Lot or Site
You locate a lot you like and put a contract to purchase it. Many builders have empty lots in their inventory, which eliminates this time-consuming step.
2) Partnering with the Builder and Architect
Consider finding a builder first before an architect. That’s because may builders have architects working for them. The success and failure of the project will be pegged on the builder. Therefore, it’s critical to find the right one.
Some tips that will help you find good builders include:
- Choose builders with local experience.
- Seek recommendations from people with newly built homes.
- Interview several builders.
Once you tell the builder your dream for the lot, it’s their job to come up with the final plans & specifications. You’ll then sign a contract with them. The contract details the project’s cost, construction term, etc.
3) Approaching the Lender
Construction loans for homeowners are typically offered by banks and the USDA. Bank loans are more common and easier to obtain. You’ll go through the following steps before obtaining them:
You meet with the bank’s mortgage consultant to discuss your needs. The consultant helps you understand the loan’s features and how much cash you can borrow.
b. Submitting your application
There is a standard loan form to fill out. After getting pre-qualified, you might receive an initial disclosure on the loan package, including the loan estimate, applicable fees, closing costs, etc.
c. Financial assessment
After the initial approval, lenders will want to verify your financial documents. They ask for your W-2s, pay stubs, etc. If you’re approved for the loan, the bank will send the commitment letter.
d. Property appraisal or review
There are two appraisals for construction loans. The first takes place before construction commences. Banks determine how much to lend by looking at the house’s specifications as detailed in the builder’s contract. The second appraisal comes before the loan conversion to figure out the value of the newly built home and verify its square footage.
e. Closing the loan
During the scheduled loan closing date all the parties meet. It’s at this stage that you sign multiple documents.
The construction phase lasts up to 12 months. Near the home completion, several activities take place including the builder obtaining the final draw, getting homeowners insurance, etc.
5) Loan Conversion
The lender converts the construction loan to a perm loan. You might pay some fees such as the outstanding interest amount, taxes, insurance, etc.
What Is a Construction Loan: Final Word
Let’s close by answering a question people commonly ask: “Do I have to sell off my current home?”No, you don’t have to sell your home as the builder works on your new residency. Use the construction window to find potential buyers or tenants for your existing property.
If you were looking forward to building your home, we hope that you now have a good basic understanding of how it works.