The benefits of owning a home are well documented — savings on rent, equity building, security, and pride of ownership. For some, what’s more valuable is the opportunity to build their own home exactly how they envision it. If you are one of those people, you’ve probably scoured the web for information on the cost of building a house.
According to Forbes, the average cost of building a home is $329,000, excluding land costs, and can even go as high as $900,000 depending on the design, house type, size, and other factors.
Add the cost of land, which ranges between $3,000 and $150,000, and the dream of homeownership will seem unattainable for the average American. But with construction loans, this dream can become a reality.
What Are Home Construction Loans?
A construction loan or a home-building loan is a short-term loan for building a custom home or a stick-built house. It covers the entire cost of building a home, from land cost to the architectural plan, permits, labor, and materials.
You can leverage building loans to handle unexpected expenses arising during the construction process through contingency reserves. Tap into the interest reserves through a construction loan, so you don’t have to make monthly interest payments out-of-pocket. An interest reserve is a portion of the loan earmarked to cover the interest payments during construction.
How Do Construction Loans Work?
Home construction loans act as bridge loans that cover the construction cost while an applicant applies for a regular mortgage to pay off the construction loan. However, the borrower can repay this loan using other means like personal loans.
The loan is typically divided into two phases: construction and permanent financing. During the construction phase, interest-only payments are made on the amount of money that has been disbursed.
Once the home is completed, the principal falls due, after which some home construction loans automatically convert to conventional mortgages.
Construction loans work differently from traditional mortgages, the primary difference being their mode of disbursement. Instead of receiving a lump sum upfront, the borrower receives funds in installments or “draws” as the construction progresses.
This allows the builder to pay for materials and labor as the needs arise, making a home-building loan a line of credit.
Unlike mortgages, construction loans aren’t specialty financing. This means stricter qualification requirements (credit history, financial stability, and architectural plans) and higher interest rates.
Additionally, the collateral isn’t as secure as with a mortgage — as it’s an unfinished house — all the more reason lenders exercise caution. The lender may also ask for an estimated construction timeline and budget and will likely send an inspector before each funding stage.
Types of Home Construction Loans
Building a home is a personalized experience, and so is financing. Banks and credit unions offer various types of home construction loans to cater to the different needs of home builders.
The main types of construction loans are construction-to-permanent and construction-only loans. However, there is also a portion of borrowers who are existing homeowners looking to finance extensive renovations. These, too, qualify for a home building loan, as demonstrated below:
Construction-Only Loans
Also known as standalone construction loans, construction-only loans are short-term loans, generally with a year-long term, that cover only the cost of building the home. As with other short-term loans, they entail high interest rates.
Other defining features of construction-only loans are their adjustable rate, two application processes, and two closings. They are due upon completion of the construction.
Some critical factors to consider before taking out a construction-only loan are the two applications and closings, which make them costlier than construction-to-permanent loans, and the fact that your financial situation could deteriorate between the time you apply for your loan and when the construction is complete. This latter could make it harder to qualify for a mortgage.
Construction-to-Permanent Loans
Also known as single-close or one-time close loans, construction-to-permanent loans are usually a combination of short-term/construction-only loans and regular mortgages. They start as the former but automatically convert to a traditional mortgage when the construction-only loan falls due.
The borrower can choose a fixed or adjustable rate for the mortgage, with terms reflecting the common 15 and 30-year periods. The most significant advantage of construction-to-permanent loans is their simplicity, as the two applications and closings are rolled into one, thus saving time and money.
Renovation Loans
Renovation loans work much like construction-to-permanent loans. They are tailored to help homeowners cover the costs of the purchase and extensive renovations or additions in one loan. Usually, the loan amount is based on the anticipated house value after renovations.
They include the Federal Housing Administration’s (FHA) 203k loan or Fannie Mae and Freddie Mac’s HomeStyle Renovation mortgages.
If you can finance the purchase or you’re an existing homeowner but need funding for renovations, there are other options to consider depending on the project cost.
For example, if you anticipate spending below $20,000, you can use a credit card or a personal loan. For renovations worth around $25,000, consider a home equity loan or line of credit, but the former would require the borrower to have considerable equity in their home.
A cash-out refinance (a new, higher mortgage that replaces the existing one) is another alternative that offers you a lump sum by tapping into your home’s equity. But this only makes sense in an environment with decreasing mortgage rates.
The standout advantage of these loans is that lenders don’t require disclosure of renovation plans and budgets.
Owner-Builder Construction Loans
In owner-builder construction loans, draws are usually made to the borrower, not a third-party contractor. A qualified, licensed, and experienced builder can self-build using this arrangement if they have a professional construction contract. This loan allows the owner total control over the project, meaning they are able to keep costs at a minimum while still maintaining quality.
End Loans
Technically speaking, end loans are not construction loans. They are traditional mortgages converted from construction-only loans or would be in place if the borrower originally financed the lot land and then obtained a construction loan for the build.
Construction Loan Rates
Like other loans, interest rates for new construction loans vary depending on the lender, borrower’s credit history, financial standing, loan-to-cost ratio (LTC), occupancy status, and loan term. Besides that, the rates fluctuate with the prime rate, meaning they can change during the loan period.
Some lenders charge interest on the disbursed amount, while others charge interest on the total loan amount, with the interest payable monthly. In general, interest rates tend to be higher for new construction loans compared to conventional mortgages, often by about 1%.
This is because construction loans are considered riskier due to their short-term nature and uncertainty of the final property value.
Qualifying for a Construction Loan
As mentioned, construction loans have a rigorous application process. The following are some of the main requirements to qualify for a construction loan:
Good to excellent credit: Borrowers are required to have a credit score of 680 and above to be considered for a construction loan. Some lenders will want a higher score. The high credit requirements are an attempt by lenders to filter out the risky borrowers, given the uncertain nature of the final value of the property. If you have plans to build a home, it is recommended that you improve your credit score to enhance your chances of qualification.
Stable income and employment history: Lenders will also evaluate your income as well as employment history to ensure you have the financial capability to repay the loan.
Low debt-to-income (DTI) ratio: Your DTI ratio is a representation of your ability to manage debt. A high DTI ratio means you have a lot of debt relative to your gross income, signaling a likelihood of struggling to make payments. Most lenders will require a DTI ratio below 45%, including the construction loan you intend to take out.
Down payment of at least 20%: Construction loans usually require a down payment of at least 20% of the total project cost. Like in conventional mortgages, the 20% down payment helps reduce the lender’s risk in case of default.
Detailed construction plans and budget: Lenders will want to ensure their money goes towards a well-thought-out and feasible project. For that reason, they ask for detailed plans as well as cost estimates from a reputable contractor before approving a construction loan.
A home appraisal: Whether you’re seeking a construction-only loan or a construction-to-permanent loan, lenders need to confirm that the home, in its finished state, will be worth the investment they are making. An appraisal will help determine the loan-to-cost ratio (LTC) by evaluating the blueprints, the lot value, and other details.
A licensed builder: Lenders understand that a construction project is only as good as the builder. They will want to protect their interests by ensuring your builder is licensed and reputable. For higher chances of success, ensure the builder has a proven track record in handling such projects and is a member of a recognized home builders’ association like the National Association of Home Builders (NAHB).
How to Get a Construction Loan
Below is a step-by-step guide to help you get a construction loan:
Find a builder: The easiest way to find a reputable builder is by asking for recommendations from friends. Alternatively, you may search for licensed builders in your area using NAHB’s online directory. Besides reputation, consider their prices.
Choose a construction loan lender: Contact several well-known construction loan lenders for information on their programs, terms, and requirements.
If finding a good match or a willing lender through this method proves challenging, check out smaller regional banks or credit unions. These tend to offer construction loans with more flexible terms and requirements.
Gather your paperwork: As part of the application process, the lender will request a contract detailing your arrangement with your builder. This contract should clearly state the project’s pricing and plans.
You will also need references for your builder and proof of their professional credentials. For your financial verification, you will be asked to submit documents similar to those required for a traditional mortgage, such as recent pay stubs.
Get pre-approved for the loan: You will want to be pre-approved for the loan by your lender before the construction begins. The mortgage lender will review your submission and either deny your application or provide you with a pre-approval letter. Without pre-approval, you might find yourself drawing up blueprints you can’t finance.
Purchase homeowners insurance: While it may sound strange to purchase insurance for an incomplete project, lenders require that you do so before they can release the funds. This is to protect their collateral against potential risks during the construction process.
Construction Loan vs. Renovation Loan
While construction loans and renovation loans both serve to finance home improvement, they differ in significant ways. A construction loan is primarily used to finance the building of a new home from scratch. On the other hand, a renovation loan funds major improvements on an existing property.
A construction loan requires an appraisal based on the home’s projected value upon completion. In contrast, a renovation loan requires both the current value of the house and the projected value after renovations. Also, the application process for a construction loan tends to be more rigorous than that of a renovation loan.
FAQs and Common Misconceptions
Is a construction loan different from a traditional mortgage?
Construction loans differ from traditional mortgages. A conventional mortgage is used to finance an existing home, while a construction loan finances the construction of a new home.
How do I qualify for a construction loan?
To qualify for a construction loan, you must have a good credit history, a stable income, a low DTI ratio, and ready funds for the 20% down payment. You will also need detailed construction plans and budget as well as an appraisal of the finished home.
What credit score do you need to qualify for a construction loan?
Most lenders require a credit score of at least 680 to approve a construction loan. However, some may have stricter requirements, so it’s best to check with your lender.
How long does it take to get a construction loan?
It takes about 45 days to get approved for a construction loan as long as the paperwork is in order and you meet the lender’s requirements.
Which is better, a construction loan or a mortgage?
A construction loan is better for financing the building of a new home, while a mortgage is better for purchasing an existing home.
Can I get a construction loan with no money down?
Yes, you can get a construction loan with no money down. VA construction loans and USDA construction loans offer zero down payment options for eligible borrowers. A down payment of 20% to 25% of the total project cost is usually required for other programs.
Work With a Reputable Lender for a Smooth Construction Loan Process
Financing is every home builder’s major obstacle, and this extends to securing a construction loan. A lot of requirements must be met, and due process must be followed for a lender to get behind your project.
The lender will want to see your commitment, financial stability, and a well-defined plan before it approves a construction loan. Sometimes, the application may fall through even after meeting the minimum criteria, meaning your choice of lender can make all the difference.
