A construction loan is a type of loan used to finance home building or renovation.
What is a construction loan?
Typically, this a short-term loan with a loan term of up to one year. This loan can help you purchase the land and then fund the construction to build on that property. After the building process is complete, the loan is usually converted into a permanent mortgage.
Construction loans are inherently more risky than traditional mortgages. Because the actual property does not yet exist, it is hard to know if this investment will be advantageous for the lender. Numerous problems could arise during the construction phase. As a result, banks fear that they would end up being the lien holder on an incomplete home.
To mitigate the risks of these loans, lenders typically charge higher interest rates on them.
How does it work?
In general, lenders pay out funds from the construction loan in stages, known as a drawdown or more simply, a payment schedule that coincides with critical construction phases. As the project completes milestones, the lender will send out an inspector to verify that the stage has been completed. Next, the money will go directly to the contractor instead of the borrower to pay for that particular phase.
There are two main kinds of home construction loans: construction-to-permanent and stand-alone loans.
In a construction-to-permanent loan, also known as a single-close construction loan, you first borrow funds to pay for the building process. After the construction is complete and you move in, the lender will then convert the loan balance into a permanent mortgage. This type of loan combines two loans into one.
Since you couple the construction loan and mortgage into one loan, you only need to apply for one loan. As a result, you only have one set of closing costs, which saves you money. Additionally, lenders will lock a maximum mortgage rate when construction begins.
With a construction-to-permanent loan, you only pay interest on the outstanding balance during the construction phase. This rate is likely variable and aligns with the prime rate determined by the Federal Reserve.
After the builder finishes your home, your loan converts to a traditional permanent mortgage. In other words, you can choose what type of interest rate you want, fixed or adjustable, and determine the loan’s term, customarily 15 or 30 years.
A stand-alone construction loan, also known as a two-close construction loan, is designed for current homeowners who may not have the 20% downpayment for an additional loan. The advantage of this type of mortgage is that you can live in your current home while the construction is underway, and you will have more cash after you sell your existing home.
After the construction is complete, you will retire that loan and pay it off by refinancing. You will need to get an appraisal and inspection of the finished project and apply for a new loan. Ideally, you will be able to sell your current home and have the funds to qualify for a more suitable permanent mortgage on your new property.
How to qualify?
As with a conventional mortgage, you will need good to excellent credit, proof of income, a low debt-to-income ratio, and a down payment of 20%.
Before you apply for a construction loan, you will need detailed construction plans. These plans include a construction timetable, detailed plans for the layout, materials, and specifications as well as a line-item budget.
Additionally, you will need to have a selected builder with sufficient work history, insurance, and references. The bank will also want to see a signed construction contract with this builder that includes beginning and end building dates.