Personal Finance

How Do Home Construction Loans Work?

A home construction loan is a short-term loan meant to cover the cost of building a home. Construction loans can be more challenging to qualify for than a mortgage. You’ll need a minimum 20% down payment, good credit, proof of stable income, and a low debt-to-income ratio.

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For many people, building their dream home is, well, a dream. When you want to make that dream a reality, there’s a good chance you’ll have to build the house using a construction loan.

If you're interested in building your own home, here's what you need to know about construction loans and how they work.

What Is a Construction Loan?

A construction loan is what it sounds like  — a loan designed to help you build your home from the ground up. However, it’s important to note that rather than being a long-term loan of up to 30 years, a construction loan covers the period when your home is under construction. Most construction loans become due in a year or less. Once the house is complete, you have to pay off the construction loan or get another, bigger loan (the actual mortgage) to pay off the cost of the building.

Your construction loan will include the following costs:

  • Land for the home
  • Labor and materials involved with building the home
  • Fees, permits, and any plans
  • Contingency reserves to cover unexpected costs
  • Interest reserves for those who don’t make interest payments during the construction
  • Closing costs

It’s important to note that construction loans are often more challenging to get than a regular mortgage, so you need to be prepared to jump through a few hoops.

How Can You Qualify for a Construction Loan?

Many construction loans come with higher interest rates than what you'd see with a standard mortgage. Additionally, depending on your situation, you might be required to sell your current home before moving forward with the construction loan.

In general, you can expect to provide the following if you want to qualify for a construction loan:

  • Down payment of at least 20%: Even though you can usually pay less for a down payment on a regular mortgage, many lenders won't accept less than 20% down for a construction loan because there's no house built yet, which means a bigger risk.
  • Higher credit score: Even though some mortgage lenders offer loans to those with scores of 620 (or sometimes less), many construction loans require that you have a higher score, sometimes at least 680, to even qualify.
  • Stable income: You need to show steady income to get any home loan, but it's essential with a construction loan.
  • Debt-to-income ratio: Many lenders are stricter about this requirement for construction loans than for more traditional mortgages. The upper limit is usually 45%, but you might need to plan for a lower ratio than that.
  • Construction plan and schedule: You need to provide your planned construction schedule. Lenders require you to have a plan and a schedule that makes sense for completing the project.
  • Builder review: You should also have a builder in mind for the project. The lender might review the builder's qualifications and previous work and check up on the progress of your home.

You'll need to have all these items in place for the most part before approaching your potential lender for money.

Types of Construction Loans

When deciding on a construction loan, consider the different types of loans available. Think about your long-term needs as you move forward.

Construction-To-Permanent Loans

This loan is probably the easiest type of loan to manage because it wraps up the construction of your home and then converts your construction loan to a mortgage when the building phase is complete. Sometimes these loans are called "single closing" loans. You lock in the interest rate at the beginning of the project and carry it through the life of the mortgage. If you have a straightforward construction plan and you want to convert to a mortgage when the house is complete, without getting another loan later, a construction-to-permanent loan can be a good choice.

Construction-Only Loans

Just as they sound, a construction-only loan will only cover the construction period. You will have to close two different loans. First, you have to get the construction loan, and later, you will need to close on a mortgage. If you have large cash reserves, you might be able to make this one work. Additionally, if you want to shop around for a lender and potentially get a better interest rate later, a construction-only loan can work. Just be ready with your other financing in place so that you can pay off the construction-only loan on time.

Resource: How to Find the Best Mortgage Rates

Renovation Construction Loans

If the home you're dealing with needs major renovations, you might be able to get a construction loan to help you cover those costs. This loan can be an option if you buy a fixer-upper instead of building a home from scratch. With major renovations, you might still need a bigger down payment. You may also need to provide a construction plan and schedule because your loan will be based on the home's projected value after you finish the renovations.

Banks That Offer Construction Loans

Not every bank offers construction loans. If you're hoping to build or renovate a home, you need to look for a lender that provides this type of financing.

  • TD Bank: Offers flexibility with different options, including single-close loans.
  • Nationwide Home Loans Group: Provides different options, including a lower credit score requirement.
  • BB&T Bank: Different types of loans, including construction-to-permanent.
  • VA Nationwide Home Loans: Offers the ability to use VA benefits to get funding for construction loans.

Have all of your documentation ready ahead of time. Also, prepare for regular inspections and continued permitting as you go through the building process. Being aware of the requirements can help you get approved for your construction loan.

FAQs

Are there higher qualification criteria for construction loans?

Yes, you will have a higher down payment and credit score requirements for construction loans.

Can construction loans cover the home design?

No. Even though construction loans can cover permits and planning, they don’t cover the actual designs for the house.

Can I use excess construction loan funds for other expenses?

No. Construction loan funds are paid directly to the builder or contractor. If you don’t use the entire amount of the loan, you don’t receive the excess funds. You’ll save money over time, though.

Bottom Line

Getting a construction loan is an involved process that can take a lot of time and effort. Before you apply for one, be sure to review the section above on how to qualify carefully. Then, gather all the documentation needed in advance. The more you prepare ahead of time, the easier it will be to avoid surprises.


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