How Home Construction Loans Work
Home construction loans provide families and individuals with the ability to finance new home construction projects. The loan term is usually short, typically lasting one year or less in most cases, and once the project is complete, the loan is converted or refinanced with a traditional mortgage.
Construction loans typically cover both the cost of the property and the construction costs of the house. These loans can often be complex and require more direct oversight and involvement from lenders than traditional home loans.
Expect to provide lenders with a ton of documentation and timetables, including the following:
- Plans for building the home.
- Estimated schedule for various stages of construction.
- A budget for the total costs of constructing the home.
In some cases, the lender may require additional documentation about the building process, such as the names of the builder or contractors performing the work. In most cases, lenders will release funds in stages and only after checking on the progress to verify the completion of a construction phase. Loan funds are used to pay contractors involved in that phase. Throughout the process, it is good to remember that lenders are partnering with you in the construction process and have a financial stake in its outcome.
During the construction phase of the project, borrowers will typically make interest-only payments on the loan. The repayment of the loan usually takes place when construction is complete, and a traditional mortgage replaces the construction loan.
Different Loan Types
Essentially there are two different types of home construction loans:
- Construction-to-Permanent Loans
- Stand-Alone Construction Loans
Construction-to-permanent loans are often the most desirable for people who intend to occupy their homes upon the completion of construction. That is because they allow you to combine the construction loan with the standard mortgage loan. It means you are not required to refinance your mortgage at a later date.
With this type of loan, you have the benefit of locking in a low-interest rate from the start. Once the building is complete, the lender converts it into a traditional mortgage at the locked-in interest rate. With this mortgage, you have the option of choosing a fixed rate or ARM (adjustable rate mortgage) and may choose between a 15- or 30-year term. You will also likely be required to put down a 20-percent or more down payment.
Stand-alone construction loans are outstanding choices for people who are building homes with the intention of reselling afterward or who have limited funds to use as a down payment. This loan requires a smaller down payment and does not lock in low mortgage interest rates, which means that if you do intend to live in the home post-construction, you will have to obtain a mortgage independently. Another downside with this type of loan is that you must pay closing costs (and the associated fees) twice: first, on the closing of the initial stand-alone construction loan; second, when you secure the mortgage for the home.
It is more difficult to qualify for a construction loan than a traditional loan because the completed home is not available to secure the loan. For this reason, you should expect to do the following:
- Provide more documentation, such as plans, timetables, builder information, etc.
- Have a credit score of 680 or better.
- Present a higher down payment (typically 20 percent or greater).
- Offer proof that you can afford to pay your monthly construction loan payments in addition to your current rent and/or mortgage costs for the duration of the construction loan.
Understanding the basics about home construction loans can help you to choose the loan that meets your needs today and in the future. Use the information here to help you make wise buying choices when exploring your options for a home construction loan.