If you’re looking for the perfect property to build a home, it can be an exciting time. Building a house is a completely different experience from buying a pre-existing home.
You get the customize the home to your exact tastes and make it your own.
You also go through a different loan process. A construction loan is what you would apply for instead of a traditional mortgage. The construction loan process and terms are different for a mortgage, and the following are things to know.
What is a Construction Loan?
Construction loans are short-term financing that covers just the costs to build a custom home. Construction loans are considered specialty financing, and then, once your home is built, you have to apply for a mortgage. That mortgage is what you use to pay for the completed home.
There are other loans available in addition to construction loans if you’re going to entirely remodel a home.
A construction-only loan is usually short-term, issued for a year.
The construction loan is only to cover the actual period of construction, and many lenders don’t offer this type of financing.
Construction loans are considered high-risk because of the many variables, like getting approval from local municipalities, the builder’s cooperation, and other factors.
The interest rate on a construction loan is often higher, and they’re harder to qualify for. You also have to pay a second set of loan fees when applying for a traditional mortgage later on.
A construction-to-permanent loan is something a custom builder can apply for. These loans fund construction, and then they convert that into a permanent mortgage. If you’re the borrower during construction, you only make interest payments. This type of loan is expensive, so comparison shop before agreeing to anything.
You might be eligible for an owner-builder loan if you’re acting as your own general contractor, but this isn’t common. The lender will require you to show that you have the experience, education, and licensing to build the home.
When you have a construction loan, the lender pays a contractor in installments as certain milestones on the project are completed.
While every project is unique, a construction loan generally will pay for land, plans, permits, and fees. These loans may also pay for labor and materials, closing costs, contingency, and interest reserves.
How Does It Work?
If you’re borrowing money to build a custom home, it can be more difficult to qualify for is because there isn’t any collateral backing the loan up like there is with a mortgage. With a traditional mortgage, the house is the collateral.
That means you’ll have to go through extra hoops as far as the lender is concerned.
The lender is going to inspect the plans thoroughly and your finances.
The disbursement of this type of loan, as mentioned, is paid to the builder in installments that are called a draw.
Every draw relates to a part of the project. For example, there may be a draw once the foundation is poured and when the house is framed. Then, there can be another when the finishing work is done.
An inspection is usually required prior to every draw being released to the builder. The payment amount is based on the work the builder’s completed, which is noted in the inspection report.
Mortgages are transactions between a borrower and lender—with a construction loan, a thirdparty is involved, the builder.
Your contractor has to be able to complete the construction on time and stay within budget, so you have to choose someone carefully.
You should go over the builder’s references and the other work they’ve done. Make sure your local building authority approves their plans.
The lender may also request work history for the builder, blueprints, proof of insurance, a materials list, a detailed budget, and a signed construction contract with a start and finish date.
What About the Down Payment?
Finally, a 20-30% down payment may be required for new construction.
Similar to other mortgages, the minimum credit score, maximum debt-to-income ratio, and down payment will vary based on the lender and your individual circumstances.
For the most part, as is the case with a traditional mortgage, your down payment is based on how much you’re borrowing.
Construction loans are tricky and not always the best option, but at the same time, if you want to build a custom home, they may be your only option.