What is a construction loan? How do they work?

If you don’t find the right house to buy, you may be wondering how much it will cost you to build a new home or to renovate your current one. It is different to borrow money to finance a project than to get a mortgage to buy a home. Here are the details about getting a construction loan.

What is a construction loan?

A home construction loan, which is a shorter-term loan with higher interest, provides the funds needed to build a residence.

Construction loans usually last for one year. This time period is when the property must be constructed and a certificate should be issued.

How does a construction loan work?

The borrower files a request for a loan construction and submits financials, plans, timelines, and other documentation.

After approval, the borrower begins to draw funds in connection with each phase. In most cases, the borrower repays interest only during construction. An inspector or appraiser assesses the build throughout construction to authorize more funds.

Once construction is completed, the borrower typically converts the loan into a permanent mortgage and begins repaying principal and interest.

Variable rates for construction loans often move with the prime. Construction loan rates tend to be higher than traditional mortgage loan rate. A traditional mortgage uses your home as collateral. The lender can take over your home if you default on payments. A home construction loan is not available to the lender. They are more likely to consider these loans higher-risk loans. You can expect construction loan interest rates to be around 1 percentage point higher than traditional mortgage rate rates. They typically fall somewhere between 5 and 10%.

The length of your construction project will determine the term of your initial loan term. Due to the short timeframe of construction loans and the fact that they are dependent upon the completion of the project you will need details about the construction schedule, plans, and a realistic budget.

Depending on the type, you may be able convert the construction loan to a conventional mortgage after the home is built. This is known as a construction-to-permanent loan. A separate mortgage may be necessary if the loan is for construction only.

Differences between construction loans versus traditional mortgages

Other than the repayment time and cost, there are a few differences between construction loans and mortgages:

The loan money distribution. This is different from personal loans and mortgages that require a lump sum payment. A construction loan lender will pay the money out in stages, as the home is built. These draws are usually made when significant milestones have been achieved, such as the foundation being laid or the framing work begins.
The amount the borrower owes. You pay interest and principal immediately when you get a mortgage. You will usually only be required to pay interest on construction loans. Borrowers will typically be required to pay interest only on any funds taken up until completion of construction.
Inspection/appraiser involvement. During construction, the lender sends an inspector or appraiser to inspect the house. Additional payments are made to the contractor by the lender if approved by the appraiser. They are known as draws. You can expect to be subject to between four and six inspections in order to track the progress.

There are many types of construction loans

Construction-to-permanent loan

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 the construction-to-permanent approach is that you have only one set of closing costs to pay, reducing your overall fees.

Janet Bossi is senior vice president at OceanFirst Bank, New Jersey. “There’s an one-time closing so there aren’t duplicate settlement fees,” she says.

Once the construction-to-permanent shift happens, the loan becomes a traditional mortgage, typically with a loan term of 15 to 30 years. After that, you will make monthly payments to cover the principal and interest. Then, you have the option of a fixed or adjustable rate mortgage. Your other options include an FHA construction-to-permanent loan — with less-stringent approval standards that can be especially helpful for some borrowers — or a VA construction loan if you’re an eligible veteran.

Construction-only loans

A construction-only mortgage provides funds to finish the building of the house. The borrower will have to pay it off at the end of its term (usually one to three years).

The percentage of the project that has been completed determines how much money is available. Interest payments are not due to the borrower.

Due to the fact that you must complete two separate loan transactions, and pay two sets fee fees, construction-only loans may end up being more costly than permanent mortgages. Closing costs are often thousands of dollars so it’s a good idea not to have another set.

You should also consider that your financial situation may change during construction. A mortgage might not be possible if you lose your job or experience other hardships.

Renovation loan

Home renovation loans are available if you prefer to remodel an existing home over building one. These can be in different forms depending on how much money you are spending.

Steve Kaminski, U.S. Head of Residential Lending, said that homeowners looking to save less than $20,000 could look into a personal loan or credit card. TD Bank says that Residential Lending is available. If the homeowner has equity in their house, a home equity loan (or line of credit) may be an option.

A cash-out refinance can also be an option, which allows homeowners to take out a mortgage at a higher rate than their existing loan. They will then receive the overage as a lump sum. This option becomes less appealing as interest rates rise.

With all of these options, the lender doesn’t usually require the homeowner to disclose how the funds will be used. The homeowner controls the budget, plan and payments. Other forms of financing will require the lender to evaluate the builder and review the budget. They will also oversee the draw schedule.

Owner-builder construction loan

Owner-builder loans are construction-to-permanent or construction-only loans where the borrower also acts in the capacity of the home builder.

Due to the complexity of building a home, and the knowledge required to meet building codes, many lenders won’t allow borrowers to be their own builders. This is usually only allowed by lenders who are licensed builders.

End loan

Kaminski clarifies that an end loan refers to the homeowner’s mortgage when the property is constructed. A construction loan is used in the building phase. It is then repaid when the construction is complete. After the construction phase is completed, the borrower will have to repay their existing mortgage. This is also called the end loan.

“Not all lenders offer a construction-to-permanent loan, which involves a single loan closing. Kaminski notes that some lenders require a second loan closing in order for borrowers to be able to obtain a permanent mortgage.

What are the terms of a construction loan?

You can use a construction loan to pay for:

The cost of the land
Contractor labor
Building materials
Permits

Kaminski suggests that you discuss these matters with your lender.

Kaminski said that many construction loans include a contingency reserve. This is to help cover unexpected costs and to provide a cushion in the event the borrower makes any changes once construction begins. It is not uncommon for a borrower, once their plans have been laid, to want to raise their countertops and cabinets.

Other costs associated with building a home

The labor and material required to build a home are not the only costs involved. The loan amount will usually cover the cost for permanent fixtures, such as landscaping and appliances. Construction loans out do not include home furnishings.

Construction loan requirements

Most construction loan companies require that borrowers:

Have a stable financial situation. A low debt-to income ratio is required in order to get a loan for construction. You also need proof of sufficient income to repay it. You will also need a minimum credit score 680.
Make a down payment. A down payment is required when you apply to the loan. The amount you borrow will depend on the lender that you choose. However, construction loans require at least 20% down.
Prepare a construction plan. It can help lenders feel more confident about your ability to repay the loan if you have detailed plans.
Get a home valuation. The collateral that will secure the loan is the finished home. You may be required to get an appraisal to determine the estimated value of the home.

How to get a loan for construction

While getting approved for a construction loan may seem like the process for getting a mortgage approval, the process to get approval to break ground on a new home is much more complex. The following five steps will help you get a construction loan.

Hire a licensed builder A lender will want to ensure that the builder is qualified to finish the project. Ask friends who have built their homes for you to recommend them. For contractors in your local area, you can use the NAHB directory of local builders’ associations. Similar to how you might compare multiple houses before buying one, you should also compare the skills and prices of different builders to find what suits your needs.
Make sure you have all the documents. A lender may ask for a contract that includes pricing details and project plans. You should have references and proof of business credentials for your builder. . You’ll likely have to submit many of the same financial documents you would provide for a traditional mortgage like pay stubs or tax statements.
Get Preapproved: Knowing how much money you can borrow for your construction project is a great way to get started. This can help you avoid paying for plans by an architect or drawing blueprints for a home you won’t be able afford.
Get homeowners’ insurance: Although you may not be living in your home, your lender will likely require that you purchase a prepaid homeowners’ insurance policy that includes builder risk coverage. If something happens during construction (e.g., the property is set on fire or it is vandalized), you will be covered.
Get homeowners’ insurance: Although you may not be living in your home, your lender may require you to have a prepaid homeowners’ insurance policy that includes builder risk coverage. If something happens during construction (e.g., the property is set on fire or it is vandalized), you will be covered.