By Miranda Marquit, Bankrate
Financing the construction of a home requires a different kind of mortgage than when you buy a new or older home. Here's what you need to know about getting a construction loan.
- What is a construction loan?
- How do construction loans work?
- Types of construction loans
- Factors to consider about construction loans
- How to get a home construction loan
- How to find a home construction loan lender
What is a construction loan?
A home construction loan is a
short-term, higher-interest loan that provides the funds required to
build a residential property, explains Janet Bossi, senior vice
president at OceanFirst Bank.
"These loans are usually one year in duration during which time the
property must be built and a certificate of occupancy issued," says
Bossi.
A construction loan is used to cover the costs of work and
materials for new-build homes. Some of the items you can finance with a
construction loan include permits, contractor labor, home and roof
framing costs, interior finishing costs and many of the other expenses
involved in building a house, according to Rick Bechtel, head of U.S.
residential lending for TD Bank.
Removable items, such as
furnishings, can't be included in home construction loans, Bechtel
points out: "For instance, landscaping, trees and grass can all be
included in a construction loan, but patio furniture cannot be."
How do construction loans work?
Construction
loans usually have variable rates that move up and down with the prime
rate, according to Bossi. Construction loan rates are typically higher
than traditional mortgage loan rates.
With a traditional mortgage, your home acts as collateral - and if you
default on your payments, the bank can seize your home. With a home
construction loan, the bank doesn't have that option, so they view these
loans as bigger risks.
Because construction loans are on such a
short timetable and they're dependent on the completion of the project,
you need to provide the lender with a construction timeline, detailed
plans and a realistic budget.
Once approved, the borrower will be
put on a bank draft or draw schedule that follows the project's
construction stages, and will typically be expected to make only
interest payments during construction. Unlike personal loans
that make a lump-sum payment, the lender pays out the money in stages
as work on the new home progresses, says Bossi. Borrowers are typically
only obligated to repay interest on any funds drawn to date until
construction is completed.
While the home is being built, the
lender has an appraiser or inspector check the house during the various
stages of construction. If approved by the appraiser, the lender makes
additional payments to the contractor, known as "draws."
Depending
on the type of construction loan, the borrower might be able to convert
the construction loan to a traditional mortgage once the home is built,
or they might be required to get a separate mortgage designed to pay
off the construction loan.
Types of construction loans
Construction-to-permanent loan
Construction-to-permanent loans provide the funds to build the dwelling and your permanent mortgage as well, explains Bossi.
In other words, with a construction-to-permanent loan, you borrow money to pay for the cost of building your home, and once the house is complete and you move in, the loan is converted to a permanent mortgage.
The benefit of this approach is that you have only one set of closing costs to pay, reducing your overall fees, says Bossi.
"There's a one-time closing so you don't pay duplicate settlement fees," says Bossi.
Once
it becomes a permanent mortgage - typically with a loan term of 15 to
30 years - then you make payments that cover both interest and the
principal. At that time, you can opt for a fixed-rate or adjustable-rate
mortgage.
Construction-only loan
A construction-only loan
provides the funds necessary to complete the building of the property,
but the borrower is responsible for either paying the loan in full at
maturity (typically one year or less) or obtaining a mortgage to secure
permanent financing, says Bossi.
The funds from these construction
loans are disbursed based upon the percentage of the project completed,
and the borrower is only responsible for interest payments on the money
drawn.
Construction loan rates are almost always tied to the
prime rate plus a margin. Additionally, they might have a higher rate
than traditional mortgages. Construction-only loans can ultimately be
costlier if you will need a permanent mortgage because you complete two
separate transactions and pay two sets of fees.
Another
consideration is that your financial situation might worsen during the
construction process. If you lose your job or face some other hardship,
you might not be able to qualify for a mortgage later on - and might not
be able to move into your new house.
Renovation loan
If
you want to upgrade an existing home rather than build one, you can look
for a renovation loan, which comes in a variety of forms depending on
the amount of money you're spending on the project.
"The range of
the loan size would dictate what the right product might be and what
options may exist," says Bechtel. "If you only need $10,000, you might
opt for an unsecured (personal) loan, using a credit card or taking out a
home equity line of credit (HELOC) against the existing equity in your home."
However, Bechtel points out, as the dollar figure gets bigger, the more mortgage-like the product becomes.
The
challenge with smaller projects that involve either unsecured loans or
HELOCs, according to Bechtel, is that the review process is not as
uniform or consistent as it is for a construction loan.
"With a
construction loan, the bank is evaluating the builder as well as the
customer to make sure the builder is a good credit risk," says Bechtel.
"There's a clear, professional process in place."
A renovation
loan, on the other hand, particularly smaller loans, doesn't require a
budget being presented to the bank. Nor are draw schedules, plans and
specifications required. The owner may just be writing a check upfront
to a builder.
"In the construction loan world, the bank is to some
degree managing the process, including the builder and the customer,"
says Bechtel. "In the renovation space, the homeowner is managing the
whole thing with the builder, and the bank is often not aware of what is
occurring."
Owner-builder construction loan
Owner-builder
loans are construction or construction-only loans where the borrower
also acts in the capacity of the home builder.
Most lenders won't
allow the borrower to act as their own builder because of the complexity
of constructing a home and experience required to comply with building
codes, says Bossi. Lenders that do typically only allow it if the
borrower is a licensed builder by trade.
End loan
An end loan is another name for a mortgage, says Bechtel.
"There
is a construction loan that's roughly 12 to 18 months in duration and
is purely for construction. When the house is done that loan gets
repaid," says Bechtel, "and then you need to go out and get an end loan,
which is just a regular mortgage. It occurs after you have completed
construction."
Factors to consider about construction loans
Before
you choose a construction loan, talk to your contractor and discuss the
timeline of building the home and if other factors could slow down the
job, such as inclement weather. Decide if you want to go through the
loan process once or twice. Consider how much the closing costs and
other fees of obtaining more than one loan will add to the project.
When getting a construction loan, you're not just accounting for building the house; you also need to purchase the land
and figure out how to handle the total cost later, perhaps with a
permanent mortgage when the home is finished. In that case, a
construction-to-permanent loan can make sense in order to avoid multiple
transactions.
If you already have a home, though, you might be
able to use the proceeds to pay down the loan. In that case, a
stand-alone construction loan might be a better choice.
Carefully consider your needs and situation before moving forward.
How to get a home construction loan
At
first glance, getting approval for a construction loan appears similar
to the process of obtaining a mortgage. However, it does come with a few
more requirements.
"Prior to making an application for a
construction loan, a borrower should have met with an architect, had
plans and specifications drawn and negotiated a contract with a builder
reflecting the total cost to build so that a loan amount can be
established," explains Bossi.
Lenders review a borrowers'
employment history, savings, income stability and ability to repay the
loan in addition to a thorough review of the plans and specifications. A
property appraisal will also be obtained to support the value of the
collateral, says Bossi.
To qualify, you'll likely need:
- Good to excellent credit
- Stable income
- Low debt-to-income ratio
- A down payment of 20 percent
How to find a home construction loan lender
"Because
construction loans are more complex transactions than a standard
mortgage, it is best to find a lender who specializes in construction
lending and isn't new to the process," says Bossi.
Check several
lenders to obtain details about their specific programs and procedures.
Don't forget to compare construction loan rates, terms and down payment
requirements to ensure you're getting the best possible deal.
If
you have trouble finding a lender willing to work with you, check out
smaller regional banks or credit unions. They might be more flexible in
their underwriting if you can show that you're a good risk, or, at the
very least, have a connection they can refer you to.
See more at Bankrate
