What are construction loans and how do they work?

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Written By KennethChing

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What are construction loans and how do they work?

You might consider how much it would cost to build or renovate a house if you are unable to find the perfect home. This is a different process than getting a mortgage to purchase a property. This article will provide all the information you need about getting a loan for construction.

What is a Construction Loan?

A home construction loan is a loan with higher interest that is short-term and provides funds to help you build your residential property.

Most construction loans are for one year. The loan must be repaid within one year.

What is the process of construction loans?

The borrower submits financials, plans, and project timelines to apply for a construction loan.

Once approved, the borrower can begin drawing funds for each phase of the project. Typically, interest is only repaid during construction. To authorize additional funds, an inspector or appraiser evaluates the construction.

After construction is complete, the borrower converts the loan to a permanent mortgage. The borrower then begins to repay principal and interest.

Variable rates on construction loans are usually linked to the prime rate. Construction loan rates are usually higher than traditional mortgage loans rates. Your home is used as collateral for a traditional mortgage. If you fail to make your payments, the lender may take your home. The lender does not have this option with a home-construction loan. Therefore, they view these loans as greater risks. Construction loan interest rates are typically 1 percentage point higher that traditional mortgage rates. They usually fall between 5-10 percent.

The term of the initial loan is generally for the duration of your construction project. Construction loans have a very short timeline and are dependent on completion. You will need to give the lender a construction timeline and detailed plans, as well as a realistic budget.

You might be eligible to convert the construction loan into a traditional mortgage depending on which type you choose. This is known as a construction-to-permanent loan. You might need to obtain a separate mortgage to repay the construction loan if the loan is only for the construction phase.

There are differences between traditional and construction loans

Construction loans and mortgages differ in a few key ways:

  • The distribution of loan money. Construction loans are not a one-time payment. Instead, the lender distributes the loan money in stages as the work progresses. These draws usually occur when important milestones have been reached, such as when the foundation is laid and the framing of a house starts.
  • The amount a borrower owes. A mortgage allows you to pay principal and interest immediately. Construction loans will require you to pay only interest during construction. Borrowers are usually only required to repay interest on funds borrowed up to the completion of construction.
  • Appraiser/inspection involvement. The lender will have an inspector or appraiser inspect the house at various stages of construction. The lender may make additional payments to the contractor if the appraisal is approved. These are called draws. To monitor progress, expect to have between four to six inspections.

Different types of construction loans

Construction-to-permanent loan

With a construction-to-permanent loan, you borrow money to pay for the cost of building your home, and once the house is complete and you move in, the loan is converted to a permanent mortgage.

The benefit of the construction-to-permanent approach is that you have only one set of closing costs to pay, reducing your overall fees.

Janet Bossi (senior vice president, OceanFirst Bank in New Jersey) says that there is a one-time close so that you don’t have to pay duplicate settlement fees.

Once the construction-to-permanent shift happens, the loan becomes a traditional mortgage, typically with a loan term of 15 to 30 years. You then make both principal and interest payments. You can then choose between a fixed-rate and an adjustable-rate mortgage. Your other options include an FHA construction-to-permanent loan — with less-stringent approval standards that can be especially helpful for some borrowers — or a VA construction loan if you’re an eligible veteran.

Construction-only loan

A construction-only loan is available to finance the cost of building the home. However, the borrower must pay the loan off in full by the due date (typically within one year) or obtain a mortgage to permanent financing.

These construction loans are based on the amount of work completed. The borrower pays only interest.

Because you have to complete two separate loans transactions and pay two sets fees, construction-only loans can be more expensive than permanent mortgages. Closing costs can run into the thousands, so it is a good idea to avoid paying another set.

Your financial situation could get worse during construction. You might be denied a mortgage if you lose your job, or are facing other hardships.

Renovation loan

You can choose to renovate an existing house rather than building one. These loans come in many forms, depending on how much you spend on the project.

Steve Kaminski from U.S., says that homeowners who are looking to renovate their home for less than $20,000 should consider getting a personal loan, or a credit card. TD Bank’s Residential Lending department says. A home equity loan or credit line may be an option for renovations that cost less than $25,000, provided the homeowner has equity in their home.

In low mortgage rates, a cash-out refinance is another option. This allows homeowners to take out a higher mortgage and then receive the excess in one lump sum. This option is less attractive as rates rise.

The lender does not usually require homeowners to disclose how they will be using the funds. The homeowner is responsible for managing the budget, the plan, and the payments. The lender will review the builder’s budget, oversee the draw schedule, and evaluate any other financing options.

Owner-builder construction loan

Owner-builder loans are construction-to-permanent or construction-only loans where the borrower also acts in the capacity of the home builder.

Because of the difficulty of building a home and the experience required to follow building codes, most lenders won’t permit the borrower act as their own builder. Most lenders won’t allow this unless the borrower is a licensed builder.

End of loan

Kaminski explained that an end loan is simply a homeowner’s mortgage after the property has been built. A construction loan is used during construction and is repaid after the work is complete. The end loan, which is also known as the mortgage, will be due back to the borrower.

“Not all lenders offer a construction-to-permanent loan, which involves a single loan closing. Kaminski states that some lenders require a second closing in order to get a permanent mortgage or an end loan.

What is a construction loan?

A construction loan can cover the following:

  • The land cost
  • Contractor labor
  • Materials for building
  • Permits

Kaminski says it’s important to talk about these issues with your lender.

Kaminski states that construction loans often include a contingency fund to cover any unexpected costs. This also acts as a cushion for borrowers who decide to make changes after construction has begun. It’s not unusual for a borrower want to raise their countertops or cabinets after the plans have been laid.

Additional costs for building a house

A home is more expensive than the labor and materials required to build it. The loan amount can usually include the cost of permanent fixtures such as appliances and landscaping. A construction loan out does not cover home furnishings.

Construction loan requirements

Companies that offer construction loans often require borrowers to:

  • You must be financially stable. You will need to have a low debt to income ratio and sufficient income to repay the construction loan. A minimum credit score of 680 is required.
  • Make a downpayment. When you apply for a loan, you will need to pay a downpayment. The amount of the loan will vary depending on which lender you choose, and how much you want to borrow for construction. Construction loans typically require at least 20% down.
  • A construction plan is essential. A detailed plan and a schedule for the project, especially if it was created by the company you are working with, can help lenders feel more confident in your ability to repay the loan.
  • Get an appraisal of your home. Your home will serve as collateral and lenders will want to ensure that the collateral is sufficient to cover the loan. They may ask you to obtain an appraisal that estimates the value of your home.

How to obtain a construction loan

Although getting approval for a loan to build a home might look similar to obtaining a mortgage or a home equity loan, it is more difficult. These are the five steps to follow if you want to obtain a construction loan.

  1. Locate a licensed builder Every lender will want to make sure that the builder who is responsible for the project has the necessary expertise to complete the house. Ask your friends for recommendations if they have built homes. To find local contractors, you can also use the NAHB’s directory listing of associations for home builders. It’s just like comparing multiple homes before purchasing one, it is wise to look at the expertise and price of different builders.
  2. Gather your documents: An lender will most likely request a contract from your builder, which includes detailed pricing and plans. Make sure you have the necessary documentation and references to your builder. . Additionally, you will likely be required to provide the same financial documents that you would for a traditional loan such as pay slips and tax statements.
  3. Get preapproved A preapproval for a construction loan will give you a good idea of the amount you can borrow to complete your project. This is a great way to avoid having to pay for plans or draw up blueprints for a house you cannot afford.
  4. Get homeowners insurance Your lender may require that you have a prepaid homeowners policy with builder’s risk coverage. You are protected if anything happens during construction, such as a fire or vandalism.
  5. Get homeowners insurance Your lender may require that you have a prepaid homeowners policy with builder’s risk coverage. You are protected if anything happens during construction, such as a fire or vandalism.

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