A majority of people looking to build a new home don’t have the cash, and must resort to a construction loan to fund the new construction. Construction loans are prevalent and necessary for builders, buyers, and investors to finance their latest projects.
What is a Construction Loan?
Construction loans are what the name implies. Simply put, they are loans used to cover building costs for new construction. Typically, they’re not a mortgage, which means a shorter term and higher interest rates.
They base the loan on the home’s market value and a construction loan on the completed project’s anticipated value compared to a mortgage.
Types of Construction Loans
While many types of loans are available, there are three that are the most common:
1. A one-time close loan will wrap all of your construction costs and your mortgage into one package. As the builder completes work, the builder receives payment from the lender, and these costs get transferred to your mortgage when you close.
With this setup, you can lock in the best interest closing interest rate to have fixed, steady payments later. Some refer to this type of loan as a construction-to-permanent loan.
2. Construction-only loans, or stand-alone construction loans, cover just the cost of construction and nothing else. Also, this type of loan is paid off in full when the work is complete. They’re great if you are flush with cash, and can afford the outlay of money.
The downside is if you need to roll the loan into a mortgage, the same qualifications apply, and you are stuck looking for another lender.
3. Fixer-upper or renovation loans require already owning a home for approval. Loans of this type are typically rolled into a mortgage when the job is complete. These loans are very popular among those who buy older or fixer-upper properties to either keep or flip to new owners after renovation.
Construction Loans for Builders
Another type of loan typically reserved for special situations is the owner-builder construction loan. If a builder plans to build a home for themselves, they can qualify for this specialized loan as long as they can certify the house they’re building is theirs.
The second type of builder construction loan is called an end loan designed for the builder-investor. The builder funds the construction costs of a new home, and the buyer secures a mortgage to pay the builder off in full for the new house.
Qualifications for Construction Loans
As you might expect, qualifying for a construction loan is more complicated than for a traditional mortgage because the lender has no collateral. Lenders don’t like risk, and this type of loan represents a higher risk.
Because they base the loan on projected value, the lender needs detailed information regarding the home. Its size, location, materials, contractors’ names, and other pertinent information will help them approve the loan.
Once that step is complete, you’re not out of the woods yet. Lenders are skittish about construction loans, and they need the reassurance of your capability of making payments during and after construction.
Lenders consider many factors about your credit and finances before approving the loan. Some of the factors are:
- A credit score of 680 or higher for consideration for a loan. Your debt-to-income ratio cannot be higher than 45 percent of your total income. Remember that lower is better in this situation.
- 20-30 percent down payment is a typical requirement by most lenders. Some renovations loans might allow for slightly less.
- Repayment plans for the loan. Lenders need to know how you plan to pay off the construction loan, whether in cash or refinancing after completion.
Conclusion
We all know that not every plan works out. But, by having adequate savings available for your project, you’re helping your case during the approval process. Lenders want to see that you have a proper down payment and enough cash on hand to fund unexpected delays if they occur.
During construction, you can expect regular, routine inspections that the lender orders. Also, the builder receives payment in the form of draws as they reach certain milestones. As you can see, it’s essential to have extra cash available if anything goes wrong and requires an immediate cash outlay.
