How Constructions Loans Work
A construction loan allows you to build your own home rather
than purchasing an existing home. The plus side is that you can design your new
house to fit your exact needs on a piece of land you chose on your own. The
downside is that getting a construction loan is more complicated than a
traditional home loan and not all lenders are willing to do them.
Here’s exactly what you can expect throughout the process to
make it as smooth as possible. With some upfront research and preparation,
you’ll be ready for any potential bumps in the road before they even occur.
When you opt for a construction loan, the approval process
doesn’t just involve you, it also involves the team working on your new home.
You’ll need to supply your lender information on the general contractor and
maybe even subcontractors. The lender will then likely run a credit check on
those parties, as well as checking to make sure they’re appropriately licensed
for the job. They may also check out the house plans to review the size,
building materials, and other details of your floor plan.
As a borrower, you’ll need to undergo a personal credit
check yourself and also have substantial savings. That’s because you’ll not
only need to make payments on your new home as it’s being built, you’ll also
need to keep up with your current rent or mortgage payments if you’re not
staying with family while you build.
Check on these financials requirements in advance to make
sure you understand the full involvement that comes with a construction loan.
There are options for bad credit borrowers with limited cash on hand for a down
payment, but those are harder to come by. Start the process early and talk to a
lender that specializes in construction lending as soon as possible before you
even start working with a builder. You don’t want to spend money on consulting
fees with a builder and then realize that the construction process doesn’t work
for your financial situation.
The inspection process with a new construction home is a
much more in-depth one than with a normal home purchase. When you buy an
existing home, you go through one inspection and then finalize negotiations
with the seller to address any concerns before you go to closing.
The inspection process with a construction loan has several steps, so be prepared before you even get started building.
Since the lender is financing a project as it’s being
completed, inspections will be done at specific intervals to ensure the work is
being done and is on schedule. The lender releases payments as different
milestones are completed. Examples of milestones include:
- Loan closing
- Lot grading
The builder then receives a payment that is drawn on the
loan in order to have the funds to keep moving forward with the project. An
inspector comes to review the progress on behalf of the lender and report back
to make sure everything is getting done correctly. This role in project
management protects both the lender and you as the borrower since the building
company knows they won’t get paid until they complete certain stages of the
A construction loan is structured differently than a regular
home loan so don’t be alarmed if you see higher interest rates. In fact, you
can definitely expect to see higher rates because of the additional risk
involved for the lender and because of those extra steps necessary to complete
the inspection process.
You’re also likely to see variable interest rates that can
change if the prime rate increases or decreases during your term. It’s
possible, although not always common, to find a lender willing to offer a fixed
rate construction loan.
The good news is that whatever option you find, the
construction loan won’t last as long as a traditional mortgage would. In fact,
the most common term is just one year, and then you would refinance to a
traditional 15- or 30-year mortgage. Plus, you’ll only pay interest on the
amount of cash that is disbursed to your contractor.
The final financial consideration is your down payment.
Working with a construction loan lender will very likely result in a higher
down payment requirement. If you already own your land, you may be able to put
down just 10%, otherwise you’ll likely need a 20% down payment.
You can also make a higher down payment than requested in
order to save on your interest rate. If you’re able to make the financial
commitment, it may be worth the long-term savings to lower your interest rate,
even if by just a fraction of a point. Look into how long it would take you to
make up the extra savings and see if it’s worth parting with that extra cash up
Once the construction of your home is complete, your
construction loan will convert to a regular mortgage. You don’t have to worry
about going through another approval process; that is done as part of the
construction loan approval. You also won’t face any new closing costs as you
switch from construction to regular mortgage. The new payments, however, do
include both interest and principal payments, plus other costs like real estate
taxes and homeowner’s insurance.
Don’t forget to plan for unexpected hurdles throughout the construction process. A healthy budget padding can come in handy more often than not.
If you’ve ever worked on a large home project before, you
know that it’s rarely a straight line from start to finish. This is especially
true when you take on a project as large as a new home. Your schedule can get
slowed down from any number of issues, such as:
- Bad weather
- Unreliable subcontractors
- Slow lead time on building
Even the best general contractor can’t control these issues,
so do be prepared for adjustments to your completion date. But if you’re
willing to take the risk and have the ability to have a financial buffer,
building your own home comes with a host of benefits.
Frequently Asked Questions
How much do you have to put down with a construction loan?
This varies depending on your lender, but in most cases, you’ll need to put down a full 20%. This is quite a bit more than what is required of a traditional mortgage. If you already own land, you may be able to get by with a smaller down payment.
Can you use the value of your land as a down payment?
Yes, if you own your land already, you may be able to reduce your down payment requirement from 20% to just 10%. Talk to your lender early on in the process to get an exact number for your situation.
How long does it take to get approved?
The approval process for a construction loan can take longer than a regular mortgage. Many lenders estimate an extra 10 days. Every lender is different, though, so this should be part of your criteria when considering different construction lenders.
Is there any risk with this type of home loan?
Yes, there’s always a risk when building a new home, which is why lenders typically charge higher interest rates.
Find a lender for your construction loan today!
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