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Financing the construction of a home requires obtaining a different kind of mortgage than when you buy a new or an older home. Knowing all the rules and how construction loans operate will speed the approval process so the contractors can start building your dream home.

Types of home construction loans

There are two types of construction loans that homeowners can seek – construction-to-permanent or stand-alone construction.

A construction-to-permanent loan combines two loans into a single one. The money to build the house is advanced in stages to the contractors as construction progresses and the balance of the loan becomes a permanent mortgage once the project is completed and the homeowner moves in.

The stand-alone construction loan consists of two loans. The first loan covers all the construction costs. The homeowner obtains a second loan or a mortgage to pay off the debt accrued from the construction of the home.

“While cash is always king, the vast majority of borrowers need financing to build their dream home,” says Christopher Guerin, vice president of origination, eLEND, a residential mortgage lender based in Parsippany, New Jersey. “That is where construction financing is helpful.”

Construction-to-perm loans

A construction-to-permanent loan is only one loan, which means there are fewer fees for a homeowner to pay.

Requirements for a construction-to-permanent loan include a down payment of at least 20 percent of the estimated mortgage. While the home is being built, a homeowner only pays the interest on the outstanding balance. The catch is that the interest rate is variable during this period, which means it can increase or decrease with current rates.

If the Federal Reserve, the central bankers, decide to raise or lower short-term interest rates, or other market factors cause rates to move, expect your payments to change also. This will impact consumers who have a larger outstanding balance, especially if the timetable to build the house is extended.

After the contractor has completed the construction, the mortgage lender changes the construction loan into a permanent mortgage, resembling other residential mortgages. Homeowners typically choose to obtain a 15-year or 30-year mortgage with a fixed-rate or adjustable-rate. Ask the lender if you can lock in the interest rate of the mortgage once the contractor breaks ground. This move may cost more in the form of a slightly higher rate but could save you thousands of dollars if rates rise while the project is underway.

One advantage of a construction-to-permanent loan is that the homeowner only submits his/her credit report and score and other financial documents once. The closing also only occurs once, saving the homeowner thousands of dollars.

“The pros of a construction-to-perm loan is that with a single loan transaction you can obtain the funds necessary to purchase land, finance the construction phase and have it become your permanent mortgage as opposed to financing each of these steps through separate loan transactions, which would require multiple loan applications, increased documentation and multiple sets of closing costs,” says Rick Scott, director of construction lending at Silverton Mortgage in Atlanta.

The interest rate charged on construction-to-perm loans will be in the same range as standard mortgage interest rates and could be either fixed or variable, he says.

This type of loan can be obtained with as little as 5 percent to 10 percent for the down payment. “If the borrower already owns their land on which they wish to build, the equity they have in their land can be used to satisfy any down payment requirements,” Scott says.

One of the obstacles to building your own home, by the way, is financing the land. Banks are not eager to loan money on raw land. For more on land loans, see this Bankrate story.

Stand-alone construction loans

Stand-alone construction loans are another option but only finance the construction of the home.

Borrowers who choose to use a permanent mortgage program that is not offered by their lender in a construction-to-perm structure would benefit from selecting a stand-alone construction loan, Scott says.

Not all lenders will offer VA loans or FHA loans in a construction-to-perm loan. In that case, the homeowner would need to obtain a standalone construction loan to finance the construction and then refinance that loan with a VA or FHA loan when the project is finished.

One major drawback of stand-alone construction loans is that the homeowner needs to obtain two separate loans. That process requires multiple loan applications and closings, plus paying two sets of closing costs.

The interest rates on standalone construction loans are sometimes slightly higher than current mortgage rates due to the shorter loan term and perceived risk by the lender.

Factors to consider on construction loans

Before you choose either loan, talk to your contractor and discuss the timeline of building the home and if other factors could slow down the job, such as inclement weather. Decide if you want to go through the loan process once or twice. Consider how much the closing costs and other fees of obtaining more than one loan will add to the project.

“Under most circumstances being able to cover all your financing needs to purchase the land, construction financing and permanent mortgage with a single transaction is better than using multiple financing vehicles as it will keep the amount of paperwork and costs to a minimum,” Scott says.

For homeowners who are planning to sell their current home and use the proceeds as an additional down payment on their new home, a stand-alone construction loan may be the best option, says Guerin.

“However, in almost every other case, a construction-to-permanent option is a more beneficial option,” he says.

Qualifying for a construction loan

Getting approval for a construction loan is similar to the process of obtaining a mortgage. Lenders will check your credit score and expect you to put at least down 20 percent down.

Since the home has not been built and can’t be used as collateral, the lender will require documentation from the contractor and architects.

Qualifying for a construction loan might be a more tedious process because of the additional paperwork.

You must have adequate savings for additional costs

The construction of a new home can be unpredictable and additional costs should be expected. Lenders will require the homeowner to have additional money set aside to pay those costs. To be sure, some of the increase in costs could occur when homeowners change their mind about the design or materials.

In some instances, a lender could increase the loan amount after closing on either construction loan type, but it will require the borrower to be “re-underwritten” and approved by the lender for the higher loan amount, Scott says.

Whether you choose either a construction-to-permanent or stand-alone construction loan, the responsibility of extra costs lies with the homeowner, Guerin says.

“In the event that the home’s construction was not correctly budgeted by the builder, traditionally that cost falls back on the builder to remedy,” he says. “If they are unable to do so, the borrower may be impacted financially by having to pay the difference.”

How to choose a home builder

Before you choose a builder, conduct your own research on the company’s reputation and history, including if any lawsuits have been filed by disgruntled customers. Obtain at least three or more bids from different builders who have experience in building homes of the type, size and scope that you’re looking to build, Scott says.

“If it’s possible, go and look at homes that were constructed by these builders,” he says. “Speaking to some of their previous clients can also give you a good idea on the builder’s responsiveness and on-time completion.”

When you’re shopping builders, be sure to compare the same quality of materials, fixtures, appliances and other factors.

Ask a builder specific questions such as the length of the warranties, if landscaping is included and other similar details. Each builder operates differently and has various criteria.

“A client should expect a home to be completely built with no responsibilities other than obtaining utility accounts and providing access to the land,” Guerin says.

Expect inspections from the lender

Inspections by the lender will occur while the home is being constructed. The lender will have an appraiser or inspector check the house during the various states of construction. Approvals from the appraiser result in the lender making additional payments to the contractor, known as “draws.”

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