What’s more exciting than having your new home built from the ground up on the land you just purchased? It’s nice and new and you will be the first one to live in it, not to mention you can usually customize some or all of the features. If you don’t have cash, you might want to consider a construction loan.
What Is a Construction Loan?
Construction loans are designed to give a buyer enough money to cover the costs of the building or rehabilitating a house or other real estate project.
A construction loan sometimes referred to as a self-build loan, is usually a one-year loan that is taken out by either the builder or the homebuyer. These loans come with a higher interest rate mortgage and a larger down payment because they are a higher risk than other loans. This is because with a traditional mortgage, the home is used as collateral so if you default, the bank gets your home. However, with a construction loan, that’s not the case making it a bigger risk.
How Do Construction Loans Work?
A construction loan is used to cover the costs of the building prior to obtaining long-term funding. As we mentioned, a construction loan is usually a one-year term and the requirement is that the house must be built and a certificate of occupancy issued within that time.
The lender pays the money from a construction loan directly to the contractor, not the buyer and it is usually paid in installments as each building milestone is reached. Once the building has been completed, that home construction loan is refinanced, changed to a permanent mortgage, or the buyer obtains a new loan which is sometimes referred to as the end loan unless the construction loan is paid in full at that time.
What Costs Does a Construction Loan Cover?
A construction loan covers the costs of all the work and any materials needed to build that home, such as:
- Land
- Building materials
- Labor
- Plans
- Fees
- Permits
- Closing costs
- Contingency reserves (if the project costs go over budget)
- Interest reserves
- Landscaping, trees, and grass
What Costs Are Not Included in a Construction Loan?
There are some costs that can’t be included in a construction loan such as home furnishings and patio furniture.
What Are the Different Types of Construction Loans?
There are several different types of construction loans you could apply for depending on your particular situation.
- Construction Only Loan
A construction only loan provides the buyer with the money needed to build a new home. These are usually one-year loans that must be paid in full by the end of the loan term. Otherwise, the buyer will need to obtain permanent financing.
The construction only loan is sometimes called a two-close construction loan. This is because with a construction only loan, you will have to complete two separate transactions and pay two different sets of fees because you have to qualify, get approved, and pay for closing costs two times—once for each loan.
- Construction-to-Permanent Loan
A construction-to-permanent loan gives a buyer the money needed to build a new home and money for the permanent mortgage as well. A construction-to-permanent loan works like this. The buyer borrows enough money to pay for the complete home build. Once the house has been completed, the buyer moves in and the loan is converted to a permanent mortgage. The construction-to-permanent loan is sometimes called a single-close construction loan because there is only ever one loan versus two loans like there is with a construction only loan.
The benefit of using a construction-to-permanent loan and that is there is only one set of closing costs you have to pay which will save you a significant amount of money by not having to pay duplicate fees.
Once the construction-to-permanent loan is converted to a permanent mortgage, the term is usually 15 to 30 years and can be either a fixed-rate or adjustable-rate-mortgage that covers both the interest and the principal. Additionally, the interest rates are locked in at the closing.
- Renovation Construction Loan
A renovation construction loan is used when a buyer wants to renovate an existing home versus building a new one. In this case, a renovation loan would cover the home purchase as well as the renovations. With a renovation loan, the costs of all the renovations are wrapped into the mortgage rather than being financed after the closing. Additionally, a renovation loan is based on the home’s value after the renovations have been completed. A renovation loan is perfect for those who find their dream home; however, it’s a fixer-upper and they need money to complete the renovations to that home.
A renovation construction loan works a little differently than other construction loans. This is because renovation loans are usually smaller amounts than a home build construction loan. Additionally, the bank review process isn’t as thorough or hands-on as it is for a home build construction loan; therefore, the bank is usually not as closely aware of what is happening with the process. Also, with a renovation loan, there are no draw schedules, plans, or other required processes.
With a construction loan, the bank pretty much handles the process which includes vetting the builder and the buyer to make sure they are both a good credit risk. They also know what monies go out and when, etc.
The benefit of financing the renovations for the home rather than using a personal loan or a home equity line of credit is that a renovation loan will generally have a lower interest rate and give you a longer-term for repayment.
- Owner-Builder Construction Loan
An owner-builder construction loan is when the owner (buyer) is also acting as the builder rather than hiring a builder to manage the process and all the subcontractors that are involved when building a home.
These loans are extremely difficult to get because most lenders won’t approve the borrower acting as their own builder. Lenders view these loans as extremely risky because of all the complexities of building a home, not to mention all the building codes, etc. that apply. Therefore, most lenders won’t approve an owner-builder construction loan unless the borrower is a licensed builder by trade.
- End Loan
We briefly talked about an end loan earlier in this article. An end loan is just another name for a permanent mortgage. A construction loan usually has a 12-month term and the money from a construction loan can only be used for the construction of that home. Once the house has been completed, the construction loan must be converted into a permanent mortgage to pay off the construction loan. This process is what is ultimately referred to as the end loan and it occurs after the completion of the home’s construction.
What Do I Need to Qualify for a Construction Loan?
A lender will usually require a 20% to 30% down payment for a construction loan. However, some renovation loans might not require quite that much. For example, the FHA 203(k) loan program has a down payment requirement as low as 3.5% which is much easier to come up with than the 20% to 30% requirement other lenders have. However, the buyer will be required to use an FHA approved lender if opting for an FHA 203(k) loan.
Other requirements to obtain a construction loan will usually include the following:
- A debt-to-income ratio of no more than 45% of the buyer’s income. The lower the debt-to-income ratio the better.
- A credit score of at least 680 or higher.
- A 20%-30% down payment. However, as we mentioned above, there are some programs that allow a lower down payment.
- With a construction-only loan, some lenders require a repayment plan. This means the lender will want to know if the buyer is going to pay the balance of the construction-only loan in cash or if he or she is planning on refinancing that loan once the new construction has been completed.
A buyer will also need proof of a stable income, have to show proof of their employment history, how much they have in savings, and proof of their ability to repay the loan, along with a thorough review of the plans and specifications for the home. Then, the lender will also need a property appraisal to support the proposed value of the home.
Things to Think About Before Applying for a Construction Loan
Since the lender is going to need a copy of the plans and specifications, before you apply for a construction loan, you should meet with an architect, have that architect draw up the plans and specifications, and negotiate a contract with the builder which shows what the total cost will be to build the home. The lender will then take that information and use it to establish a loan amount.
At this point, it’s important that you make sure your financial situation is secure; otherwise, if your financial situation worsens such as losing a job or some other financial hardship during construction, you might not qualify for a permanent mortgage once the house is completed, and you wouldn’t be able to move in.
You should also talk with the building contractor to go over a proposed start to finish timeline for building that home. However, please keep in mind there are other factors that could change that timeline such as the weather and other unpredictable factors.
Additionally, don’t forget that when building a new home from the ground up, you will need to purchase the land in addition to purchasing the home. This cost will also be needed for figuring out the overall total cost which you will need later when you refinance the construction loan to a permanent mortgage once the home is finished.
It’s always best to take some time to do a little research and know exactly what you’re getting into before moving forward. This will ensure you know what’s expected and when, how the process will progress, what your role is, what you need to do, and how to oversee everything and everyone each step of the way without having to trust that everyone else is doing what they are supposed to be doing. This will also help ensure you aren’t taken advantage of because you are uneducated in the process and what needs to be done.
Commonly Asked Questions About Construction Loans
1. Are there any closing costs with a construction loan?
Yes, there are closing costs with a construction loan. However, how many times you have to pay closing costs will depend on what type of construction loan you have. For example, a one-close construction loan which is also called a construction-to-permanent loan. Or a construction loan that requires you to pay closing costs twice. Once for the closing costs on the construction loan then again when converting the construction loan to a permanent loan.
2. Is a construction loan harder to get than a regular mortgage?
Yes, it is. This is because construction loans are short-term and, therefore, carry more risk. Additionally, the approval process is different than a regular mortgage.
3. How do I qualify for an FHA construction loan?
To qualify for an FHA construction loan, you must meet the minimum qualifying requirements which include the following.
- A minimum credit score of 580.
- A debt-to-income ratio of 43% or less.
- A minimum down payment of 3.5% for a HUD-approved project.
- A loan amount that isn’t higher than the area’s FHA loan limits.
4. Do new home builders offer financing?
Some home builders these days can arrange for mortgage financing for your new home. This is because many builders own mortgage subsidiaries and others have affiliate relationships with third-party mortgage companies. However, generally, with builder financing the rates and origination fees are higher, the closing costs will be higher, and there is the possibility of price manipulation. There is a law that states that when providing a discount, the builder’s affiliated lenders have to provide genuine savings. But, that doesn’t mean there won’t be hidden charges somewhere else.
What’s Next?
If you want advice, recommendations, or more information about construction loans, please Contact Lakeland Real Estate Group. We have been helping home buyers in Florida buy and build their dream homes for more than 20 years. We promise to provide you with the highest level of service using the most current information available along with skilled analysis, sound advice, and effective negotiation.
Additional New Construction Home Resources
Making sure you are well informed when choosing a builder can save you a lot of headaches when purchasing a new construction home.
Getting a loan for the land is slightly different from traditional home financing, so it is worth understanding the nuances of these various types of financing when it comes to buying your land before building your home.
The importance of considering today’s decorating trends is to get you thinking about the spaces in your new construction home.
Don’t forget to request our Free Buyer’s Guide. We look forward to serving you!
About the author: The above real estate article “Important Information About Construction Loans” was written by Petra Norris of Lakeland Real Estate Group, Inc. With over 20 years of combined experience in selling or buying, we would love to share our knowledge and expertise. Petra can be reached via email at petra@petranorris.com or by phone at 863-712-4207