How Do Home Construction Loans Work?

There is nothing like building your house from scratch.
Building from scratch can allow you to avoid some of the blockages of a previously occupied residence, like termites, water damage, unintuitive room layouts, or disastrous wallpaper. You can start from a clean slate.
Of course, you will have to pay for it, and one way to finance this kind of project is with a home construction loan.
Construction loans are popular for building new homes – but you will need to take into account the strict financial underwriting and construction processes and potential delays due to COVID-19.
What is a construction loan?
A home construction loan is a short-term, high-interest loan that finances the costs of building a new home. Once the house is built, you either have to pay off the loan or fold the borrowed amount into a traditional 15 or 30 year mortgage, either with the same lender or with a different lender. These loans have loan terms of one year and typically cover the costs of land (unless you already own it), labor, materials, closing costs, and permits. Funds are usually paid to the building contractor directly instead of the owner – although the owner will ultimately be responsible for paying off the construction loan once the house is built.
How do construction loans work?
Construction loans are used to finance a new home or major renovations, such as a new roof or kitchen renovation.
In general, lenders view these types of loans as riskier investments. Unlike a standing house, a bank’s appraiser cannot physically inspect and appraise the property with new construction. “They have to assess based on what they read on a piece of paper,” says Michael Foguth, president and founder of Foguth Financial Group. And it’s even more difficult for custom-built homes compared to pre-existing and proven designs.
To offset the risk, the interest rates on construction loans (usually variable) are higher than those on conventional mortgages because banks consider building a new home to be riskier than buying a home. already built. You will probably also need to make a deposit of between 20% and 25%.
The approval process is also much more difficult. With traditional mortgages, your home is collateral and the banks have recourse (ie repossession of the home) if you can’t pay it off. With a home construction loan, you are approved based on the strength of the master plan, the viability of the construction schedule, and the reputation of your building contractor. During the application process, the lender relies heavily on your contractor to provide a detailed construction plan, schedule, and budget for the project.
Once the loan is taken out – if you are approved – the lender will pay part of the funds to the builder according to the construction schedule. Thereafter, you are expected to pay interest only on the loan during the construction phase.
Once construction is complete, you enter a repayment period (and you have two separate mortgage payments) or convert the loan to a traditional mortgage, with the construction loan payments incorporated into your monthly mortgage payments. Both Foguth and Reyes recommended the latter option (called a construction loan to a permanent loan), for the convenience of a one-time payment and going through the underwriting process and paying closing costs only once. .
How the pandemic affected construction loans
Construction is taking longer than usual due to the COVID-19 pandemic as the Washington post reported in June. Labor is harder to find, the supply of housing in high-demand areas is already tight, and materials may be delayed or in short supply due to other disruptions in the supply chain. In some jurisdictions, quarantine warrants that have been put into effect in response to coronavirus outbreaks have completely blocked construction.
Residential construction is down year over year, although banks increased lending in the second quarter of this year after the initial wave of COVID-19 outbreaks, according to a S&P Global report. During the same period, banks recorded a peak of $ 850 million in arrears on residential construction loans.
Types of construction loans
There are five main types of home construction loans, all of which vary in affordability, interest rate, and eligibility requirements. Here’s what you need to know about each of them.
1. Construction loan to a permanent loan
Also known as a C2P loan, one-step or single-close, a permanent construction loan finances both construction costs and the permanent mortgage. So instead of taking out two separate loans (in which you would have to pay two sets of closing costs), your loan would convert to a 15 or 30 year mortgage once construction is complete.
2. Ready for construction only
A construction-only loan is a short-term loan that only pays the costs of building a house. At the end of the loan (usually one year), you will either need to pay off the loan in full or refinance it into a separate mortgage. One downside is that you will have to go through the loan underwriting process twice and pay two sets of closing costs.
3. Renovation loan
A home improvement loan is for homebuyers who want to rehabilitate new homes with a loan that incorporates construction costs into the mortgage. But unlike other methods of financing renovation (second mortgage and cash-out refinancing), which require little or no supervision, home improvement loans are subject to the same scrutiny as other construction loans. The lender checks your contractor, budget, and construction schedule – and distributes funds to the builder according to the draw schedule if you are approved.
4. Construction loan for the owner-builder
Homeowner construction loans are subsets of permanent or construction-only construction loans in which the home buyer himself acts as the building contractor. “You will need certificates and licenses to prove that you are competent to build this house” for this type of loan, says Mark Reyes, CFP, expert in financial advice at Albert, an automated money management and investment application. Foguth adds that if you’ve never had significant experience building homes before, the likelihood of you being approved for a construction loan is “zero”.
5. End of loan
An end loan is another term for the mortgage taken out after construction is completed. It is considered to be the mortgage that the construction loan turns into after the house is completed and construction is completed. A final loan can also refer to a separate long-term refinance that a homeowner can use to pay off a construction loan, instead of paying off all at once.
Pro tip
Check that your building contractor is licensed and insured before agreeing to work with him. You can also check their reputation with your state’s consumer protection agency and the Better Business Bureau.
Things to consider when obtaining a construction loan
Interest rate
Construction loans usually have adjustable rates that go up and down depending on the market. Since the loan term is usually one year, you probably won’t experience too many fluctuations. But keep in mind that construction loans tend to have higher rates than mortgages for existing homes because the lender takes on more risk with the expectation that the house will be built correctly and on time.
Significant fixed costs
Most lenders expect a minimum down payment of 20% or more on a construction loan. And if you go for a construction-only loan, you’ll have to pay off the loan in full after the house is built or refinance the costs into a separate mortgage or final loan.
Construction plans and schedule
Your building contractor will play a key role in the loan underwriting process. The contractor will need to present the building plan, schedule and budget to your lender, where they will verify that the plan is complete and secure and assess the likelihood that you will repay the loan at the end.
Make sure you have a realistic schedule and budget in place for the project, taking into account the time needed to account for possible delays. Your timeline can be affected by seasonality, which is available in your area and the pandemic as a whole, Reyes says. “If you start in winter, will snow and rain affect the feasibility of that and push it back another season?” Is there a shortage of supplies, such as cedar or timber framing, in your area? Will you need to import material? “
Knowing what issues you might be having will help you set expectations for the construction process – and it might help alleviate any delays that could force an extension on your loan.
How to get a construction loan
Qualifications
The eligibility criteria for a home construction loan vary by lender, but in general, you will need to meet the following criteria:
- Employee with stable income
- Low debt-to-income ratio (maximum 45%)
- Good to excellent credit score
- Deposit of at least 20%
- Approval of contractor, budget and schedule
Find a lender
Regional banks and credit unions are often your best bet for a home construction loan, Reyes says. They tend to offer competitive rates and have pre-existing relationships with builders in your area, which can make the construction underwriting process easier.
You will want to go with a lender who has experience in taking out construction loans for people who have been in similar situations to you, as your experience with a lender may differ depending on the type of home you are building.
“If you’re building a custom house, you’re going to want to interview the bank as much as they interview you,” Foguth says. “If you build a standard subdivision house, where there can be a hundred [built] already go with the same bank that did them all. They won’t take you through the construction underwriting process, just the financial underwriting. “