How To Get A Home Loan To Build A House: What You Need To Know About Construction Loans
We all have our own vision of our dream home. But some people take it to the next level, dreaming up their future homes down to the last detail. If you're one of those people, then you should know by now that house hunting can often prove to be unsatisfying. After all, purchasing a home is a huge investment, and you wouldn't want to spend thousands of dollars on something you aren't completely happy with.
If this sounds like you, perhaps you're more suited to building your home from the ground up. However, financing a home that has yet to be built is not quite the same as taking out a traditional mortgage. Here, we'll walk you through everything you need to know about construction loans. By the end of this article, you should be able to put the question "how to get a home loan to build a house" to bed once and for all – and start turning your dream home into a reality.
Understanding The Construction Loan
A construction loan, also known as a self-build loan or a construction mortgage, is a short-term loan used to finance a home construction project. By short-term, we mean that these loans typically last no longer than one year. These types of loans are also offered at a higher interest than your typical mortgage.
How Is A Construction Loan Different From A Traditional Mortgage?
There are a few key differences between traditional home loans (or mortgages) and construction loans:
Higher interest: Because there is no existing home yet, lenders don't have anything to take as collateral in the event that the borrower cannot continue repaying the loan. Since lenders have more to lose with a construction loan, they hike up interest rates to make up for the risks.
More requirements: Lenders need to make sure their money is going to be budgeted properly. As such, they require their borrowers to submit detailed documentation of their plans, including a construction timeline and a budget.
Interest-only payments: During the construction period, borrowers are usually asked to make interest-only payments. Instead of making monthly payments, a borrower gets an appraisal during different stages of construction, then pays in "draws" based on the appraisal. Interest is charged only on the amount drawn.
Higher down payment: Again, this has to do with the inherent risks involved with financing something that doesn't exist yet. Government-backed home loans can require as little as three to five percent down payment, while construction loans can require up to 25 percent.
What Does A Construction Loan Cover?
A construction loan will cover the following costs:
Materials: This involves everything needed to build the home, from roof framings to paint.
Labor: This covers the cost of hiring a contractor and all the workers needed to complete the project.
Interior finishings: Lighting fixtures, plumbing, trim, space division systems, and the like are all covered by a construction loan.
Permits: This includes all the necessary paperwork required to build a house, such as electrical, plumbing, roofing, and fence permits.
A construction loan does not cover furnishings or anything in the house that can be moved, such as decor, furniture, and appliances.
The Types Of Construction Loans
Before you start taking out a construction loan, make sure you know the difference between the types of loans available to homeowners:
1. Construction-To-Permanent Loan
Also known as a C2P loan, one-step loan, or a single-close loan, this type of loan provides borrowers not only with the funds needed to build their homes but to finance a permanent mortgage as well.
Essentially, your lender provides you with the funds to complete your home. Once it is built, your loan is converted into a permanent mortgage. This conversion process is called refinancing or modification. With a C2P, borrowers avoid having to pay for closing costs and down payments all over again.
2. Construction-Only Loan
As its name suggests, a construction-only loan covers the cost of building a new home. However, once, the house has been completed, you'll need to secure another mortgage to cover the cost. This means paying a second round of closing costs and down payments.
3. Home Renovation Loan
If you don't want to get a new house just yet, you can opt for a home renovation loan, which covers the cost of refurbishing a part of or an entire house. A home renovation loan can also come in handy if you're interested in purchasing an existing house and remodeling it to be more suited to your aesthetic and lifestyle.
4. Owner-Builder Loan
An owner-builder loan is a loan given to a borrower who wants to pursue the construction of their new home without the help of a contractor. In this case, the owner acts as the builder. Owner-builder loans are harder to come by since lenders want to make sure their money doesn't go to waste. Oftentimes, lenders will require owner-builders to secure a license before offering the loan.
How To Get A Construction Loan
Whether you want to start work on new construction or are hoping to renovate a fixer-upper, there are a few key requirements you need to meet to qualify for a construction loan:
Secure All The Documents
Your lender may require you to submit documentation of the following:
Proof of income (in the form of recent payslips and income tax returns)
Recent bank statements
A list of your assets and liabilities
An overview of your debts, including the loan amount, monthly payments, and interest rate
Your credit score
This list is in no way comprehensive, meaning that some lenders may ask for more requirements than listed above.
Find A Qualified Contractor
Without a licensed general contractor, lenders are less likely to award you with a construction loan. The more established your contractor is (and the better their track record), the better your chances are of securing that home loan.
What Should You Look For In A Contractor?
First, you should hire someone with a lot of experience under their belt. The best contractors are the ones who've dipped their toes into every aspect of home building, from designing a home down to the most basic repairs. Next, you always want someone who has a good reputation. When narrowing down your list, you can ask previous clients about their experiences with your prospective contractor, as well as look at reviews online.
Finally, you want a contractor who listens. After all, this is your dream home. While you should definitely welcome professional advice, don't let your contractor walk all over you and change all your plans too. Just like any good relationship, you should be able to communicate well with your contractor to achieve your dream home.
Prepare The Blue Book
A "blue book" is a comprehensive document detailing everything from the project timeline, floor plans, and even profit projections. Your blue book should also include a list of all the materials and suppliers needed for the project, as well as all the subcontractors you'll be working with. Essentially, your blue book helps you "pitch" your case to lenders, assuring them that you have a clear and feasible plan.
Get An Appraisal
An appraiser will determine the value of your home prior to construction. Appraisers take several factors into consideration when determining your future home's value, including the location of your land, the current market condition, and the proposed features in your home.
Prepare The Down Payment
As mentioned earlier, home construction loans tend to require higher down payments than regular mortgages. Some lenders may even ask for up to 25 percent of the total loan amount. Before you even think about securing a construction loan, make sure you've done your research and estimated the value of new construction in the area of your choice.
Is A Construction Loan Worth It?
Here are a few advantages and disadvantages to help you decide:
You only have to pay for interest: With a construction loan, you don't have to pay off the principal until the construction is completed. This means you'll have at most one year to save up for your mortgage.
The added scrutiny will push you to create more detailed plans: Because lenders are so strict about documentation, planning, and following through on those plans, you're forced to become more stringent with yourself. This is good because you end up being more meticulous about getting things done on time and staying within budget.
You get to plan and build a home based on your exact preferences: Obviously, the biggest advantage of securing a construction loan is getting to build your dream home. Instead of settling for whatever's on the market, you can make sure you get everything you want in a house because at the end of the day, you're in charge of the project.
There are a lot of requirements: Lenders have to make sure their money is in safe hands, so they ask for a ton of paperwork, from proof of income and employment to the specific details of your construction plans. This can take ages to put together.
Higher interest: Aside from being charged higher-than-usual interest, you may have to deal with a floating or variable interest rate as well. This means that your interest rate can change over time, making it difficult to project just how much you're expected to pay each month.
Higher down payment: As mentioned earlier, this type of loan requires a higher down payment. This is because lenders don't have anything to secure as collateral.
If you've got a specific vision for what your dream home should look like, a construction loan can help you turn that dream into a reality. However, achieving your vision comes at a cost – a long list of requirements, stricter lenders, and high upfront fees.
Whether you'd like to secure a C2P loan, an owner-builder loan, or even just a regular mortgage, Wesley Mortgage, LLC can guide you through all the complicated processes of financing a home.