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Home construction loans explained

Build your knowledge about these complex mortgages before hammering the first nail.

© Trong Nguyen/ShutterstockA closeup of a newly constructed roof.


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 can be used to cover the cost of the land, contractor labor, building materials, permits and more.

It’s important to discuss these items with your lender, specifically what will be included in your loan-to-value calculation, according to Steve Kaminski, head of Residential Lending at TD Bank.

"Oftentimes, construction loans will include a contingency reserve to cover unexpected costs that could arise during construction, which also serves as a cushion in case the borrower decides to make any upgrades once the construction begins," Kaminski says. "It’s not uncommon for a borrower to want to elevate their countertops or cabinets once the plans are laid out."

While things like home furnishings generally are not covered within a construction loan, permanent fixtures like appliances and landscaping can be included.


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 lender can seize your home. With a home construction loan, the lender doesn't have that option, so they tend to 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 draft or draw schedule that follows the project's construction stages, and will typically be expected to make only interest payments during the construction stage. 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 for 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.

"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.

“If a homeowner is looking to spend less than $20,000, they could consider getting a personal loan or using a credit card to finance the renovation," Kaminski says. "For renovations starting at $25,000 or so, a home equity loan or line of credit may be appropriate, if the homeowner has built up equity in their home. HELOCs are typically the most affordable way to borrow a large sum of money because of their low interest rates."

Another strong option in the current low mortgage rate environment is a cash-out refinance, whereby a homeowner would take out a new mortgage at a higher amount than their current loan and receive that overage in a lump sum. This is another effective, affordable way to tap your home’s equity to improve your property, Kaminski points out.

With any of these options, the lender generally does not require disclosure of how the homeowner will use the funds. The homeowner manages the budget, the plan and the payments.

Meanwhile, using a construction loan to finance a renovation is a more thorough process. Unlike with other forms of financing, the lender will evaluate the builder, review the budget and oversee the draw schedule, and overall manage the process.

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 simply refers to the homeowner’s mortgage once the property is built, Kaminski explains. A construction loan is used during the building phase and is repaid once the construction is completed. A borrower will then have their regular mortgage to pay off, also known as the end loan.

“Not all lenders offer a construction-to-permanent loan, which involves a single loan closing. Some require a second closing to move into the permanent mortgage, or an end loan," Kaminski says.


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 closings.

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.


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
  • A low debt-to-income ratio
  • A down payment of at least 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 for your situation.

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

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Finance Magazine: Home construction loans explained
Home construction loans explained
Build your knowledge about these complex mortgages before hammering the first nail.
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