If you are having trouble finding the ideal house to purchase, you may be considering how much it would cost to either build a new home or renovate the one you already own. Obtaining a mortgage to purchase an existing home is not the same as borrowing the money for this project. Here is all the information you require for obtaining a construction loan.
A construction loan is what?
A house construction loan is a brief, higher-interest loan used to finance the construction of a residential building.
Typically, construction loans last for a year. The property needs to be constructed within this time, and an occupancy certificate needs to be given out.
How do financing for building work?
Typically, the interest rate for construction loans is variable and fluctuates along with the prime rate. Rates on construction loans are often higher than those on conventional mortgage loans. Your home serves as collateral for a standard mortgage; if you fall behind on your payments, the lender may confiscate your home. The lender does not have that choice with a house building loan, so they typically see these loans as carrying higher risks.
You must give the lender a construction timeframe, thorough drawings, and a reasonable budget because construction loans have such a tight timeline and are reliant on the project's completion.
Following approval, the borrower will be put on a draft or draw schedule that corresponds to the project's building phases. During this time, they are normally just required to make interest payments. The lender disburses the funds in phases as the construction of the new home advances, unlike personal loans that provide a lump-sum payment.
These draws typically take place when significant milestones are reached, as when the foundation is set or the house's framing starts. Typically, until construction is finished, borrowers are only required to repay interest on any money that have already been drawn.
The lender hires an appraiser or inspector to examine the house as it is being built and at various phases of construction. The lender makes additional payments to the contractor known as draws if the appraiser approves them. Expect to have four to six inspections to check on the development.
Once the house is finished, the borrower may be able to convert the construction loan into a conventional mortgage, depending on the type of loan. A construction-to-permanent loan is what this is. The borrower might be forced to obtain a different mortgage intended to pay off the construction loan if the loan is only for the construction phase.
What is covered by a construction loan?
A construction loan can be used to pay for a variety of items, such as:
- The cost of the land
- Contractor labor
- Building materials
- Permits
While permanent fixtures like appliances and landscaping may be included in a construction loan, things like home furniture are typically not.
According to Steve Kaminski, head of U.S. residential lending at TD Bank, it's crucial to go over these matters with your lender, particularly what will be taken into account in your loan-to-value calculation.
According to Kaminski, "contingency reserves are frequently included in construction loans to cover unforeseen costs that could develop during construction, serving as a cushion in case the borrower decides to make any upgrades once the building begins." Once the blueprints are drawn up, it's not unusual for a borrower to wish to raise their countertops or cabinets.
Construction loan types
Financing for construction to permanent
In a construction-to-permanent loan, you take out a loan to cover the cost of building your home, and after it is finished and you move in, the loan is converted to a permanent mortgage.
The advantage of using the construction-to-permanent method is that you only have to pay one set of closing expenses, which lowers your overall expenditures.
Janet Bossi, senior vice president at OceanFirst Bank in New Jersey, explains that there is a single closing to prevent duplicate settlement expenses from being incurred.
The loan converts to a regular mortgage after the construction-to-permanent transfer takes place, often with a loan duration of 15 to 30 years. Then, you make payments that cover the principal as well as interest. You will then be able to choose between a fixed-rate and an adjustable-rate mortgage. Your other options include a VA construction loan if you're an eligible veteran or an FHA construction-to-permanent loan, which has less strict approval conditions and may be very beneficial for some borrowers.
Loans exclusively for construction
A construction-only loan provides the money required to finish the home's construction, but the borrower is still responsible for making the loan's full payment when it matures (usually in one year or less) or securing a mortgage to secure long-term financing.
The borrower is only liable for the interest payments on the money obtained; the funds from these construction loans are disbursed according to the percentage of the project finished.
If you require a permanent mortgage, construction-only loans may end up costing more because you must complete two different loan procedures and pay two sets of fees. Since closing expenses can run into the thousands of dollars, avoiding another set is beneficial.
Another thing to think about is the possibility that things could get worse financially while the construction is going on. You might not be able to get a mortgage in the future if you have a job loss or another hardship, which would prevent you from moving into your new home.
Construction loan
You can examine home renovation financing alternatives if you decide to renovate an existing home rather than building one. Depending on how much money you're investing in the project, can come in a variety of formats.
"A homeowner could consider acquiring a personal loan or utilizing a credit card to finance the remodeling if they are looking to spend less than $20,000," adds Kaminski. If the homeowner has accumulated equity in their property, a home equity loan or line of credit may be appropriate for renovations costing up to $25,000 or so.
A cash-out refinance is an additional realistic choice in the current context of low mortgage rates, whereby a homeowner would take out a new mortgage at a higher amount than their existing loan and get the excess in a lump sum.
The lender often does not need disclosure of how the homeowner will utilize the funds with any of these options. The homeowner oversees the plan, the payments, and the budget. In the case of alternative financing, the lender will assess the builder, go through the budget, and manage the draw timeline.
Construction loan for owner-builders
Construction-to-permanent or construction-only loans with owner builders are those when the borrower also serves as the home builder.
Due to the intricacy of building a home and the expertise needed to adhere to building rules, the majority of lenders won't permit the borrower to act as their own builder. If a lender does, they frequently only let it if the borrower works as a licensed builder.
Final loan
According to Kaminski, an end loan is just the homeowner's mortgage once the building is complete. When construction is underway, a construction loan is taken out and repaid afterward. The end loan, often known as the borrower's regular mortgage, will subsequently be due.
A construction-to-permanent loan, which only requires one loan closing, is not something that many lenders offer. Some need an end loan or a second closing to convert to a permanent mortgage, according to Kaminski.
Conditions for construction loans
You will require a good credit score, a low debt-to-income ratio, and a means of demonstrating sufficient income to repay the loan in order to qualify for a construction loan.
When you apply for the loan, you must also put money down. The sum will vary according to the lender you select and the amount you're attempting to borrow to cover building costs.
Additionally, a lot of lenders want to see that you have a plan. Lenders may feel more secure in your ability to repay the loan if you have a thorough plan, particularly if it was created by the building business you're intending to work with.
Including an evaluation that projects the value of the completed house is also beneficial. Lenders want to make sure the collateral will be adequate to secure the loan because the residence will act as collateral for the loan.
How to obtain a loan for building
While getting authorized for a construction loan may resemble the process of acquiring a mortgage, getting approved to start construction on a new house is a little trickier.
How to apply for a construction loan
- Finding a licensed builder is important since any lender will want to be sure that the builder is qualified to finish the home. Ask for referrals from friends who have built their own homes. To identify contractors in your area, you can also consult the NAHB's database of regional home builders' associations. It makes sense to evaluate many builders to pick the one whose price and experience best suit your needs, just as you would if you were buying an existing home.
- Get your paperwork ready: A contract with your builder that includes specific costs and project plans will probably be requested by a lender. Make sure your builder has references and other required documentation proving their legitimacy as a business.
- Obtain preapproval: Finding out how much you may borrow for the project by being preapproved for a construction loan can be useful. This can be a crucial step to take in order to prevent paying for architectural plans or creating blueprints for a house you won't be able to buy.
Considerations for building loan factors
Do the following important self-evaluation exercises before applying for a building loan.
Could there be serious time-related problems with your project?
Speak with your builder about the timetable for the home's construction and any potential delays. The lack of materials is currently one of the greatest issues affecting construction projects. More than 90% of builders have reported dealing with shortages of appliances, timber, and oriented strand board, an engineered wood product used for walls, floors, and other things, according to a May 2021 study by the National Association of Home Builders. Obtaining windows and doors was a problem for 87% of builders, among other necessary items.
Would you like to make borrowing easier?
Choose between going through the lending process twice with a construction-only loan or just once with a construction-to-permanent loan. Think about how much the project will cost you in closing fees and other fees if you get more than one loan. When applying for a construction loan, you must consider more than just the cost of building the house; you must also consider the cost of buying the land and how you will cover the remaining balance, possibly with a long-term mortgage once the house is complete. A construction-to-permanent loan can be advantageous in that situation to prevent multiple closings. However, if you already own a property, you might be able to utilize the money to reduce your debt. A construction-only loan might be a better option in that situation.
Do you currently have homeowners insurance?
Your lender will probably want a pre-paid homeowners insurance policy that includes builder's risk coverage even though you don't yet reside in the house. This manner, you are safeguarded in the event that something unfortunate occurs while building is ongoing—say, the property catches fire midway through development or is vandalized.
How to locate a lender for construction loans
To make sure you're getting the best deal for your circumstances, speak with a number of knowledgeable construction loan lenders to learn more about their individual policies and programs. You should also evaluate construction loan rates, terms, and down payment needs.
It is important to locate a lender who specializes in construction lending and is experienced with the procedure because building loans are more complicated than regular mortgage transactions, according to Bossi.
Check out smaller regional banks or credit unions if you're having problems finding a lender who will deal with you. If you can demonstrate that you're a good risk or, at the very least, have a connection they can recommend you to, they might be more lenient in their underwriting.
