How Does A Construction Loan Work: What You’ll Need To Get Started
Building your dream house is no easy feat. Home construction often comes with a hefty price tag that may seem overwhelming. This is where construction loans come in handy.
Construction loans are used to cover the cost of building your home. Unlike a traditional mortgage which is based on the condition of a house and its fair market value, a construction loan is based on projected value. After construction is completed, these loans are typically converted into a standard mortgage.
If you’re looking to build a house from the ground up, this may be your best option. But, how does a construction loan work? In this guide, we’ll be breaking down and discussing everything you need to know!
How Do Construction Loans Work Differently From Standard Loans?
With a typical mortgage, once a deal is made and you move in, your loan is paid off over the course of 15-30 years, though lengths may vary from lender to lender. Construction loans differ in that they are short-term loans that are used to finance the building or restoration of your residence. Only after construction is completed and approved are you allowed to move in.
With a construction loan, lenders may require the borrowers to fully pay off the loan once the building process is completed. Other lenders give borrowers the option to either refinance their loan into standard long-term mortgages or take out a new loan (often called an end loan) to pay off the first.
Besides having to pass the usual credit checks, you’ll have to provide your lender with a detailed project plan and timeline. Your lender may also need to approve the contractor or company that will be working on your home.
Lenders consider loans for construction to be relatively riskier than home loans, which means they often have higher interest rates than a traditional mortgage. On the upside, interest rates are only calculated based on the funds used thus far, so with proper budgeting, this could work to your advantage.
How Do Payments Work?
Rather than lump sums, construction loans work in concurrence with your construction process. Once your loan for construction is approved and you’re ready to break ground, your lender will release the first ‘draw’ of your funds.
The funds often go directly to the builder or contractor rather than to the borrower. You’ll get the next draw after each stage of construction is completed and inspected by the bank. These are called progress payments and are broken down into five stages:
Slab-Down Or Base
The initial amount or draw your lender will release will cover construction work on the foundation of your property. This stage includes things like leveling the ground, waterproofing, and plumbing.
Once your foundation is completed, your second draw will be released. This covers the construction of the frame or skeleton of your home, including partial brickwork, roofing, and windows.
As your home takes shape, the third draw will cover your external walls, windows, and doors will be put in. During this stage, your house becomes “lockable” and secure.
Fixing Or Fit-Out
Once you have a solid structure, you can begin to work on internal fittings and fixtures. This is the stage where the inside of your house starts to look more like a home. This includes plumbing, electricity, gutters, as well as plasterboards, shelving or storage, and benches.
This draw is used for finishing touches on fixtures, plumbing, and electricity. This also covers final payments for your workers and equipment as well as overall cleanup.
Types Of Construction Loans
There are several types of construction loans for you to choose from. You and your lender will have to determine which suits your situation best, as each will have its own benefits.
A construction-to-permanent loan covers the cost of the construction of your new home. Once your residence is complete and you have moved in, the loan is automatically converted into a permanent mortgage.
The advantage of this type of construction loan is convenience. All the financing you have to think about is processed in one transaction. It’s a one-time closing, which means you only have to go through the approval process once and won’t end up having to pay multiple settlement fees.
This may make the process cheaper for you, and you won’t have to worry about financing a separate permanent loan once your house is complete.
As the name states, this loan only covers the funds necessary for your home construction. You have a couple of options for paying back this type of loan.
One option is that you pay back the loan in full once the building is complete; typically within a year. Another is to obtain a separate permanent mortgage to pay back the first. It may seem like a hassle to go through two processes, but the benefit is that you have the freedom to shop around for loans and find a deal or lender that works best for you.
The risk with this construction loan is that if you encounter unforeseen financial issues during the building process and are unable to pay the short-term loan, you may not be able to move into your home. You may also have difficulties securing a secondary standard mortgage to pay off this one.
A less common variant of construction-only loans is the owner-builder loan. This is where the borrower also acts as a builder, in which case the funds go directly to the borrower. Your lender will typically only grant this type of loan if the borrower is a licensed builder by profession, as they will have to know how to comply with strict building codes.
If you’re looking to restore or renovate a home rather than build one from the ground up, there are a variety of renovation loans to choose from. The 203(k) Loan is one type that provides the borrower with the funds necessary to both purchase and renovate a home.
You may also only be looking to take out a much smaller loan to renovate an existing home. In this case, you may opt to take out a personal loan using a home equity line of credit or HELOC against the equity of your home.
With a construction-to-permanent loan or a construction-only loan, banks have a hand in managing and overseeing your process. In contrast, renovation loans do not require a detailed budget, schedule, and specifications.
This makes the review process a little more challenging and unstructured, which makes this option best suited for smaller-scale projects.
Pros And Cons Of A Construction Loan
A construction loan is interest-only until the building of your home is complete. Meaning, you have more time to save money throughout the process.
A construction loan will offer much more flexible terms in comparison to traditional loans. As long as you provide the bank with specific plans, you’ll be able to figure out terms that best suit the needs of your project.
Banks will give your project structure. Though it may seem like a bit of a hassle having them watch over your shoulder, they ensure you stay on schedule and don’t go over budget.
The risk is much higher, especially for construction-only loans. Be sure you can qualify for a second loan, or have a good backup plan in case something doesn’t work out.
Because home construction loans are considered higher risk than traditional loans, they’re harder to qualify for and may necessitate a higher down payment. Banks typically ask for 20% down payment and a credit score of at least 680.
Construction loans often have higher interest rates than a typical mortgage since they follow the prime rates of banks.
Tips For Applying For A Construction Loan
Have conversations with lenders about your situation before planning your home with your contractor. This helps you gauge how much you’ll be able to borrow, and in turn, spend on construction. In other words, you’ll be able to plan around your budget.
Likewise, before you settle on a construction loan, talk to your contractors. Once you have an estimated figure of how much you’ll be able to borrow, hash out a detailed timeline for your home. Plan for uncontrollable factors such as weather and see if this is workable around requirements of the construction loan you are choosing.
Work with a good builder. It may be tempting to go cheap, but you’ll want someone professional and experienced. They will be able to work well within limitations of a construction loan, stick within budget and schedules, and advise you if they see better options.
Have a good understanding of your financial situation and the requirements lenders will need before applying for construction loans. Knowing where you are financially will help you gauge what type of construction loan or mortgage you’ll be able to handle and decide what lender suits your needs best.
Be organized with your files. It sounds like a no-brainer tip, but this is often overlooked. Have both digital and physical copies in case anything goes missing. This will save you headaches later!
If you’ve been dreaming about building your own home but aren’t able to pay for everything upfront, a construction loan might be your best option. With the right research and guidance, you’ll be well on your way to living under your very own roof.
Our trusted team of experts at Wesley Mortgage, LLC can provide you with that exact guidance. Contact us today to learn more!