Building a new home can be exciting. Yet, new construction requires a lot of planning, and securing financing can be more difficult than with a traditional mortgage. That’s why we’re here to walk you through how to get a home construction loan, the types of loans available, and everything else you need to know to start building your dream home.
How do you get a construction loan?
In general, getting a construction loan is a similar process to obtaining a mortgage, but there are more factors involved. With a home mortgage, if you default on your loan, the bank can foreclose on your home and the house itself acts as collateral. A construction loan is considered higher risk because there is no such collateral. As such, these types of loans normally come with higher interest rates and some of the following requirements:
- Good to excellent credit
- Stable income
- Low debt-to-income ratio
- A down payment of 20%
Prior to applying for a construction loan, you should meet with an architect, have your home plans and specifications, and determine the overall cost of the project so you know the size of the loan you will need. Lenders will want to see your project timeline, plans and budget, as well as your employment history, savings, income stability, credit score and DTI ratio.
Unlike purchasing an existing home, your costs are not fixed. Construction costs may increase as your project progresses and you’ll need to have extra funds available for contingencies during the build. Lenders will want to be sure that you are using a reputable builder, so they will want to make sure that your builder is properly vetted.
How is a construction loan different from a personal loan or mortgage?
Construction loans are set up differently than other loans. They are typically high-interest loans given out over a short period of time. Typically, terms are for one year during which time the home must be built and a certificate of occupancy issued.
Additionally, construction loans are not given out as a lump sum like other loans. Instead, the bank pays out the money in stages as the building process progresses. As you request the bank to pay out funds, they may send a representative to check on the construction site. You are only obligated to repay interest on the funds drawn to date until construction is completed.
What types of construction loans are available?
There are three main types of construction loans to consider:
- Construction-to-permanent loan provides the funds for your construction as well as your mortgage. You borrow what you need to build your house and then, once construction is complete, the loan converts to a permanent mortgage with a 15 to 30-year term. As with a traditional mortgage, you can opt for fixed or variable rate interest. The key benefit to this type of loan is that you only have to pay one set of closing costs.
- Construction-only loan, as the name implies, only provides the funds for your construction. As mentioned earlier, this is a short-term, high-interest loan where you pay interest only on the money drawn. If you need a mortgage as well, this type of loan may cost you more than a construction-to-permanent loan, because you will have to pay two sets of closing costs and additional fees. This type of loan can also be risky because if you lose your job or encounter other financial difficulties during construction you may not be able to qualify for a mortgage later.
- Renovation loans are typically less stringent than a loan for new home construction. Depending on the size of the loan, you may not have to present plans and specs or come up with a schedule for drawing funds. If you don’t need much money for renovation you may choose to get a personal loan or a home equity line of credit. But if you require greater funds for a larger renovation, a home construction loan can be helpful because the bank will evaluate the builder you hire and help manage the process.
As you get started on the journey of building your dream home, keep these tips in mind so you make the right decisions for your needs. If you’re not sure what kind of construction loan you need, our experienced home loan consultants can you make the right decision.