Building a brand-new home to your exact specifications may sound like a dream come true. But home development can get pretty complicated, especially if you need to take out a loan to pay for it.
From construction time tables to the various types of construction-specific loans available, here’s everything you need to know about getting funding.
What is a home construction loan?
A home construction loan is a short-term, higher-interest loan that provides the funds required to build a residential property, explained Janet Bossi, senior vice president at OceanFirst Bank.
“These loans are usually one year in duration during which time the property must be built and a certificate of occupancy issued,” said Bossi.
Unlike personal loans that make a lump-sum payment, the lender pays out the money in stages as work on the new home progresses, added Bossi. Borrowers are typically only obligated to repay interest on any funds drawn to date until construction is completed.
Construction loans have variable rates that move up and down with the prime rate, she added. And the rates on this type of loan are higher than those on traditional mortgages. Why are rates higher on construction loans? With a traditional mortgage, your home acts as collateral. If you default on your payments, the bank can seize your home. With a home construction loan, the bank doesn’t have that option, so they view these loans as bigger risks.
To obtain such a loan, the lender typically needs to see a construction timetable, detailed plans and a realistic budget.
“In order to obtain construction loan financing the borrower will need to have a builders contract including the draw schedule of how the builder expects construction funds to be advanced, a comprehensive budget outlining the cost or allocation for each construction item, and the timeframe in which the project is to be completed,” explained Bossi.
Once approved, the borrower will be put on a bank draft or draw schedule that follows the project’s construction stages and will typically be expected to make only interest payments during construction.
As funds are requested, the lender will usually send someone to check on the job’s progress.
Types of home construction loans
1. Construction-to-permanent loan
Construction to permanent loans provide the funds to build the dwelling and your permanent mortgage as well, explained Bossi.
In other words, under a construction-to-permanent loan, you borrow money to pay for the cost of building your home and then once the house is complete and you move in, the loan is converted to a permanent mortgage.
The benefit of this approach is that you have only one set of closing costs to pay, reducing the overall fees you’ll pay, said Bossi.
“There’s a one-time closing so you don’t pay duplicate settlement fees,” said Bossi.
Once it becomes a permanent mortgage — with a loan term of 15 to 30 years — then you’ll make payments that cover both interest and the principal. At that time, you can opt for a fixed-rate or variable-rate mortgage.
2. Construction-only loan
A construction-only loan provides the funds necessary to complete the building of the property, but the borrower is responsible for either paying the loan in full at maturity (typically one year or less) or obtaining a mortgage to secure permanent financing, said Bossi.
The funds from the loan are disbursed based upon the percentage of the project completed, and the borrower is only responsible for interest payments on the money drawn, Bossi added.
Construction-only loans are almost always tied to prime rate plus a margin. For example, your rate might be the current Wall Street Journal prime rate of 5.25 percent plus 2 percent more. “These loans are subject to a change in the interest rate every time the prime moves,” Bossi said.
Construction-only loans can ultimately be costlier if you will need a permanent mortgage as well. That’s because you will be completing two separate transactions and paying two sets of fees, said Bossi.
“These are two separate loans that are totally independent of one another,” said Bossi. “Two loans, two complete sets of financing expenses.”
One other point to keep in mind when considering this process. If your financial situation worsens during the construction process, due to a job loss, for example, you might not be able to qualify for a mortgage later on that actually allows you to move into your new house.
3. Renovation loan
A renovation loan can come in a variety of forms depending on the amount of money the homeowner is spending on the project, explained Rick Bechtel, head of U.S. residential lending for TD Bank.
“The range of the loan size would dictate what the right product might be and what options may exist,” said Bechtel.
“If you only need $10,000, you might opt for an unsecured (personal) loan, using a credit card or taking out a home equity line of credit (HELOC) against the existing equity in your home. A renovation loan could be any one of those product types,” added Bechtel. But as the dollar figure gets bigger, the more mortgage-like the product becomes.”
The challenge with smaller projects that involve either unsecured loans or HELOCs, said Bechtel, is that the review process is not as uniform or consistent as it is for a construction loan.
“With a construction loan, the bank is evaluating the builder as well as the customer, to make sure the builder is a good credit risk,” said Bechtel. “There’s a clear, professional process in place.”
A renovation loan on the other hand, particularly smaller loans, doesn’t require a budget being presented to the bank. Nor are draw schedules, plans and specifications required. The owner may just be writing a check up front to a builder.
“In the construction loan world, the bank is to some degree managing the process, including the builder and the customer,” said Bechtel. “In the renovation space, the homeowner is managing the whole thing with the builder, and the bank is often not aware of what is occurring.”
4. Owner-builder construction loans
Owner-builder loans are construction or construction-only loans where the borrower also acts in the capacity of home builder.
Most lenders will not allow the borrower to act as their own builder because of the complexity of constructing a home and experience required to comply with complex building codes, said Bossi. Lenders that do typically only allow it if the borrower is a licensed builder by trade.
5. End loans
An end loan is another name for a mortgage, said Bechtel.
“There is a construction loan that’s roughly 12 to 18 months in duration and is purely for construction. When the house is done that loan gets repaid,” said Bechtel. “And then you need to go out and get an end loan, which is just a regular mortgage. It occurs after you have completed construction.”
How do construction loans work for a new home?
If you want to build a new home, know that you have a more difficult road ahead of you than if you pursued a traditional mortgage for an existing home.
“For a construction loan you provide all of the same documents and materials you would provide the bank if you were just buying a house — tax returns, bank statements and pay statements,” said Bechtel. “You are going to give us the same documents whether you’re building a house or buying a house. But in a construction loan you’re also giving us plans and specifications, budgets, and a builder’s financial info sometimes.”
In other words, said Bechtel, there are three underwriting jobs taking place for a construction loan. The bank is underwriting you (the homeowner), the project itself and also the builder.
“We are going to evaluate the project. In this sense the bank and the buyer are on the same team,” said Bechtel. “The bank is going to evaluate the contract with you, the customer, to determine if the costs provided by the builder seem right. The bank is evaluating the project to make sure what the builder told you what the cost would be is actually the market cost. Or conversely, we are checking to see if the builder doesn’t adequately account for project costs.”
It’s important for the homeowner to have a significant cash cushion when seeking a construction loan, just in case the project runs over budget, which might be caused by the builder underestimating costs, said Bechtel.
If you don’t qualify for a home construction loan right now, focus on boosting your credit score and building your savings so that you can build your dream home later on.
What construction loans cover?
A construction loan is used to cover the costs of work and materials for new-build homes. Some of the items you can finance with a construction loan include permits, contractor labor, home and roof framing costs, interior finishing costs and many of the other expenses involved in building a house.
One of the things that cannot be financed with a construction loan, however, is removable items, such as furnishings, said Bechtel.
“For instance, landscaping, trees and grass can all be included in a construction loan,” said Bechtel. “But patio furniture cannot be.”
How to get a home construction loan?
Qualifying for a home construction loan is not all that different from obtaining a mortgage, said Bossi. However, the borrower may need to have additional reserves available, as construction costs often increase as work progresses.
“Prior to making an application for a construction loan a borrower should have met with an architect, had plans and specifications drawn, and negotiated a contract with a builder reflecting the total cost to build so that a loan amount can be established,” explained Bossi.
Lenders will review a borrowers’ employment history, savings, income stability and ability to repay the loan in addition to a thorough review of the plans and specifications. A property appraisal will also be obtained to support the value of the collateral, said Bossi.
With a traditional mortgage, your home acts as collateral. If you default on your payments, the bank can seize your home. With a home construction loan, the bank doesn’t have that option, so they view these loans as bigger risks.
To offset that risk, home construction loan lenders tend to have more stringent requirements.
To qualify, you’ll likely need:
- Good to excellent credit
- Stable income
- Low debt-to-income ratio
- A down payment of 20 percent
How to find a home construction loan lender
Not all lenders provide construction loan financing, so finding the right lender will definitely require a little work, said Bossi.
It’s a good idea to check with several lenders to obtain details about their specific programs and procedures as rates, terms and down payment requirements can be very different from lender to lender.
“Because construction loans are more complex transactions than a standard mortgage, it is best to find a lender who specializes in construction lending and isn’t new to the process,” said Bossi.
If you have trouble finding a lender willing to work with you, check out smaller regional banks or credit unions, which may be more likely to help.