It may sound like a dream come true to create a brand-new home to your exact specifications. But home construction can get pretty complicated, especially if you have to take out loans to pay for it.
From construction time tables to the different types of build-specific loans available, here’s all 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 needed to build a residential property, OceanFirst Bank senior vice president Janet.
Unlike personal loans requiring a lump-sum payment, the lender is paying out the money in phases as construction progresses on the new home.
Typically, borrowers are only required to repay interest on any funds drawn up to date until construction is complete.
Building loans have variable rates which move up and down with the prime rate, she added. And the rates for such loans are higher than those for traditional mortgages.
Why are rates on construction loans higher? Your house serves as insurance, with a traditional mortgage. The bank will seize your home if you default on the payments.
The bank does not have that option with a home construction loan, so they see these loans as greater risks.
To obtain such a loan, typically the lender needs to see a timetable for construction, detailed plans, and a realistic budget.
In order to obtain construction loan funding, the applicant will need a builders contract including the draw schedule of how construction funds are supposed to be advanced by the contractor, a detailed budget detailing the expense or allocation for each construction item, and the timeline within which the project is to be completed.
Once approved, the borrower will be placed on a draft bank or draw schedule that follows the construction phases of the project, and typically only interest payments will be expected during construction.
When funds are sought, normally the lender may send someone to verify the progress of the work.
Types of home Construction loans?
1. Construction –to-Permanent Loan
Building to permanent loans also provides the funds to build the dwelling and your permanent mortgage.
In other words, under a construction-to-permanent loan, you borrow money to pay for the cost of constructing your home, and then the loan will be converted into a permanent mortgage once the house is full and you move into.
The advantage of this approach is that you only have to pay one set of closing costs, reducing the overall fees you will be paying.
There is a one-time closure so that you don’t incur double settlement fees.
Once it becomes a fixed mortgage — with a loan term of 15 to 30 years — then you will make payments that cover interest as well as the principal. You may apply for a fixed-rate or variable-rate mortgage at that time.
2. Construction only Loan
A construction-only loan provides the necessary funds to complete the construction of the house, but the borrower is responsible for either paying the loan in full at maturity (usually one year or less) or securing a mortgage to receive permanent funding.
The loan funds are disbursed based on the percentage of completed project, and the borrower is solely responsible for paying interest on the money borrowed.
Building-only loans are almost always bound to a prime rate plus a margin. For example, the current Wall Street Journal prime rate of 5.25 percent plus 2 percent higher could be your rate. These loans are subject to interest rate changes each time the prime shifts.
Eventually, build-only loans can be more costly if you need a permanent mortgage too. That’s because two separate transactions will be completed and two sets of fees will be paid.
These are two distinct loans that are completely separate from each other. Two loans, two full sets of expenditures on funding.
Another thing to keep in mind when this process is being considered. If, for example, the financial situation worsens during the construction process because of a job loss, you might not be able to qualify for a mortgage later on which you can actually move into your new house.
3. Renovation Loans
A renovation loan may come in a variety of forms depending on how much money the homeowner spends on the project, explained Rick Bechtel, head of TD Bank’s U.S. residential lending.
The loan size range will determine what might be the right product, and what alternatives might exist.
If you need just $10,000, you might opt for an unsecured (personal) loan, using a credit card or taking out a credit line of home equity (HELOC) against the current equity in your property.
Any of those types of products could be a construction loan. But, as the dollar figure grows larger, the more the product becomes like a mortgage.
The problem with smaller projects requiring either unsecured loans or HELOCs is that the review process isn’t as clear or uniform as it is for a construction loan.
The bank evaluates the builder as well as the customer with a construction loan, to ensure the builder is a good credit risk. A clear, professional process is in place.
In comparison, a renovation loan, especially smaller loans, does not require a budget to be submitted to the bank. It is not necessary to draw schedules, plans and specifications. The owner can simply write to a builder a check up front.
In the world of construction loans, the bank manages the process to some extent including the builder and the customer.
The homeowner does the whole thing with the contractor in the construction room, and the bank is often unaware of what is happening.
4. Owner-Lender Construction loans
Owner-builder loans are construction or build-only loans where the borrower also acts as home builder.
Most lenders won’t let the borrower act as their own builder because of the complexity of building a home and the experience needed to comply with complex building codes, Bossi said. Usually, borrowers only require it if the borrower is a trading approved builder.
5. End Loans
An end loan is a different name to a mortgage, Bechtel said.
“There is a construction loan that lasts from 12 to 18 months, and is for building purposes only. That loan gets repaid when the house is done. And then you have to go out and get a normal mortgage end loan. This happens after the building has been finished.
How do building loans work for a new home?
Know that you have a more difficult road ahead of you if you want to build a new home than if you’ve chosen a conventional mortgage for an existing home.
You would provide the bank with all the same paperwork and materials for a construction loan if you were just buying a house — tax returns, bank statements, and pay statements.
You will give us the same documents whether you are constructing a house or buying a house.
But in a construction loan you also sometimes send us plans and requirements, budgets and the financial information of a contractor.
There are three construction-loan underwriting jobs taking place. You (the homeowner) are underwritten by the mortgage, the project itself and the contractor too.
“We are assessing the project. The Bank and buyer are on the same side in this context. The bank must review the contract with you, the client, to decide whether the costs that the contractor has given appear right.
The bank is reviewing the project to make sure the cost of the market actually is what the contractor told you what the cost would be. Or vice versa, we’re checking to see if the builder doesn’t properly account for project costs.
When seeking a construction loan, it’s important for the homeowner to have a significant cash cushion, just in case the project runs over budget, which could be caused by the builder underestimating costs.
If you’re not eligible for a home construction loan right now, focus on increasing your credit score and building your investments so that you can build your dream home later.
What does Construction loans covers?
A construction loan for new-build homes is used to cover the cost of labor and materials. Some of the items that you can finance with a building loan include permits, contract labor, cost of home and roof framing, cost of interior finishing and many of the other costs involved in building a house.
However, one of the things that can’t be financed with a construction loan is removable items, like furnishings.
For example, a construction loan could include landscaping, trees, and grass, “Bechtel said. But it can’t be outdoor furniture.
How to get a home Construction Loan?
Not all that different from getting a mortgage is applying for a home-building loan. Nevertheless, since construction costs often escalate as work progresses, the applicant may need additional funds.
Until applying for a building loan, a borrower should have consulted an architect, drawn up plans and specifications, and signed a contract with a contractor that represents the overall building costs so that a loan amount can be set.
In addition to a thorough review of the plans and specifications, lenders will review a borrowers ‘ employment history, savings, income stability and the ability to repay the loan.
A property valuation to affirm the value of the collateral will also be provided. Your house serves as insurance, with a traditional mortgage.
The bank will seize your home if you default on the payments. The bank does not have that option with a home construction loan, so they see such loans as greater risks.