If you want to build a new home from scratch, you're probably going to need a construction loan.
This is a short-term loan that can be used to finance land, materials, and labor – in short, all the costs associated with building a home.
Construction loans come in a few different varieties. Some must be paid as soon as the house is built, and some can be converted into a mortgage that you pay over time.,
The right type of construction loan for you depends on your budget, your construction schedule, and how you plan to use the home after it is built.
Check your home loans eligibility (4. February 2021)
In this article (Skip to…)
- What is a construction loan?
- How building loans work
- Construction Loan Types
- Steps to get a construction loan
- Construction loan vs., Renovation loan
- Why to finance home renovations
- Construction Loan FAQ
Home construction loan explained
unless you can pay-out-of-pocket to build a new home, you need a construction loan to finance theproject.
Construction loans allow you to finance the materials and labor to build a home from scratch-unlike a traditional mortgage loan, which is only for completed homes.
A construction loan is a short-term loan-usually 12 to 18 months-that provides funds for the materials and labor needed to build the residence.,
The money from this loan can also be used to buy the lot on which the home is built (or you can get a separate "lot loan" for this purpose).
Interest rates on construction loans are variable, meaning they can change throughout the life of the loan.
But in general, construction loan rates are usually about 1 percent higher than mortgage rates.
Check your new interest rate (4. February 2021)
How building loans work
With a construction loan, you usually don't get the full loan amount up front., Instead, you get the loan in installments to pay for the construction work gradually.
Michael Gevurtz, CEO of Bluebird Companies, explains how it works:
" First, create an estimated budget for the entire project. Then make at least the minimum down payment required by the lender," he says.
As the construction project progresses, you can gradually withdraw the loan money to cover the associated costs. Each "draw" pays the builder for this completed phase of construction.,
"Typically, the work is completed, then you submit a loan disbursement application," Gevurtz says.
"The lender sends out an inspector to review the work and approve the request. Then a portion of the loan can be transferred or deposited into your bank account."
Construction loan types
There are three main types of construction loans:
- A construction-to-permanent loan finances the construction costs as well as the finished home., It converts from an initial adjustable-rate construction loan to a fixed-rate, permanent mortgage loan once the work is completed
- A construction loan is a short-term loan with an adjustable interest rate that is used only to complete the construction of your home. Once this happens, this loan must either be paid off in full or refinanced into a mortgage loan for permanent financing
- An owner-builder loan is for homeowners who also want to act as a general contractor for their own project. "These loans can be more affordable and offer lower interest rates than the other two options., But lenders often see it as a very high risk, so it may be harder to obtain, Gevurtz says. You usually have to be a professional contractor to get one
As with a mortgage, you want to explore all your financing options and compare quotes from a few different lenders.
The right type of construction loan for you depends on your finances, your timeline and who can offer you the best interest rate for your situation.
Steps to obtain a construction loan
It can be harder to qualify for a construction loan than a conventional mortgage.,
"It depends on your financial strength as a borrower, your plans and specifications for the project, your project budget and what you plan to do with the house once it's finished," explains Robert Withers of M1 Capital Corp.
Each lender has its own application process and requirements., In general, however, you'll need to provide detailed information about your:
- Income
- Employer
- Credit (scores usually need to be above 720)
- Down payment (you will likely need at least 10%)
- Building owner/general contractor
- Construction budget
At some point, you'll also need to have the property appraised and inspected.
Once the loan is approved, the loan would eventually close through a title company as a mortgage loan.,
Instead of receiving a lump sum payout at closing, your borrowed funds are withdrawn on demand at each stage of the construction project.
" You should choose a construction lender based on their experience in construction financing. Shop carefully," Withers suggests.
He warns that finding and qualifying for a construction loan is especially difficult these days because of the current economic downturn.,
To help you find the best offer for home construction financing, it may be worth looking for an experienced and reputable brokerto help you compare loanoptions.
Construction loan vs. Renovation loan
Construction loan funds can be used to pay for land, supplies, labor, and other costs related to building a home.
But what if you want to buy a fixer-upper home instead?
In this case, you would like to take out a "rehab loan" instead of a construction loan., Funds from a rehabilitation or renovation loan can cover the cost of repairing or remodeling an existing home.
One popular renovation loan is an FHA 203k rehab loan.
"This way you can borrow money to buy the house as well as pay for desired or needed repairs or renovations," says Paul Welden, director of the 203k Contractor Certification Program.
"FHA 203k loans cannot be used for new construction. And they can only be used on existing one- to four-unit properties that have been closed for at least one year.,"
Welden adds that an FHA 203kloan requires a minimum of 3.Requires 5 percent down – which is quite a bit less than the 10 to 20 percent required for a construction loan.
Similar to construction loans, FHA 203k interest rates can be up to one percentage point higher than a traditional FHA mortgage loan.
Check your renovation loan eligibility (4. February 2021)
Options for financing renovations to an existing home
Construction loan to finance new construction.,Homeowners who want to renovatean existing home have other options, including:
- Home Equity Loans: these "second" mortgages tap into the value of your current home so you can use it for renovation projects. If you already have an existing mortgage, you will be making mortgage payments on both loans
- Home Equity Lines of Credit: This loan, also called a HELOC, taps your equity, but you control when and how you take loan proceeds. You can draw a portion of the HELOC or all of it at closing. You pay interest only on the amount you draw., You can also pay it off and then reuse the loan for additional projects within a specified time period.
- Cash-out refinance loans: You can replace your current home loan with a new loan large enough to fund your home improvement projects and pay off your existing mortgage. The "cash-out" refers to the equity you can take from your existing home
All three of these options require you to build equity in your home. The amount of money you can withdraw depends on your current equityand value of your home.,
If you don't use VA cash-out refinancing, you can't withdraw 100 percent of your equity.
Check your eligibility for renovation loans (4. February 2021)
Building Loan FAQ
Do you have any questions? Here are some quick answers, mainly from Gevurtz, to frequently asked questions about construction loans.
No, you can't get a construction loan with nothing. A borrower must have cash or equity available for a construction loan.,
In addition to a detailed plan and a qualified, approved borrower, you also need money for a down payment and proof of ability to repay the loan.
As with a traditional mortgage, proof of your "ability to repay" will come in the form of credit reports, bank statements, W2s and other documents to verify that you have sufficient, steady income to repay the loan.
Is it easier to get a construction loan than a mortgage?,
Because of the risk associated with construction loans, they are more difficult to obtain than a mortgage.
When a construction loan is used, an interest reserve fund is built into the total amount to be used for interest payments during construction.
A down payment of at least 10 percent is usually recommended for a construction loan, although 20 percent is often preferable for lenders.
Private lenders and regional banks are often best for construction loans. They lend themselves to greater risk and offer more innovative solutions.
What is the average interest rate for construction loans?
As of this writing, depending on the lender, 4.5 percent is a typical interest rate for construction loans. It's about one percent higher than a typical mortgage loan rate over the same time period.
What is a good credit score to get a construction loan?,
You may need a higher credit score to qualify for a construction loan than most mortgage loans. A FICO score of 720 or higher is recommended for loan approval.
What is the recommended debt ratio for a construction loan?
The ideal debt-to-income ratio for a home loan can vary, but it should never exceed 45 percent.
Usually it is cheaper to build than to buy a house., That's because you can create something exactly to your specifications and desires usually under cost than what you would pay for buying an existing home.
That is, it is more difficult to qualify for a construction loan than a mortgage. For many people, it is simply more realistic to buy an existing home-especially for first-time buyers.
A draw schedule is the plan that details how you will send money to the builder. If you are building a home, don't send the entire loan payment to the builder before the project even begins., This calls for trouble. Rather, your lender will release funds slowly as each project milestone is completed. Foundation done? Some funds released. Framing done? More money for the builder. This way you minimize losses with a dishonest builder or one who simply goes out of business during your project.
In this way, a construction loan resembles a line of credit. A "draw" is taken in portions at a time instead of a lump sum.
What are the closing costs of a construction loan?
Construction loans require closing costs just like conventional mortgage loans., Along with the processing and origination fees that mortgage lenders charge, you would also have to pay an appraisal, title insurance and attorney fees.
One benefit of construction-to-permanent financing pays only one set of closing costs. With a construction loan, you would pay closing costs twice: once for the construction loan and once for the permanent loan.
Do construction loans require private mortgage insurance?
Yes, a mortgage lender requires private mortgage insurance for a construction loan if you amortize less than 20 percent.,
Why construction loan rates are higher than standard mortgage rates?
With a standard mortgage, the lender can use the existing home as collateral. With a construction loan, the new home does not yet exist and therefore cannot be used to secure the loan. The real estate property you purchased has a value, but the loan amount usually exceeds the value of the property itself. Mortgage lenders reflect this added risk by charging higher interest rates.
Online banking has made it easier to get a standard mortgage, but a construction loan usually requires more face-to-face interaction with a loan officer. To be approved, you must share the unique details of your new home project.
This depends on your individual needs, and a loan officer might be able to help you make that decision.
For many borrowers, a construction-only temporary loan can provide more flexibility., For example, if you are ready for permanent financing, you have more control over the long-term loan because it is separate from the construction loan.
However, a single construction-to-permanent loan could save money on closing costs.
What are today's mortgage rates?
Interest rates remain near all-time lows for mortgages as well as other types of financing like construction loans.
But as always, prices vary depending on the person. So get a few quotes to see which lender can offer you the best deal.,