How construction loans can help you finance your dream home
A mortgage is required for the purchase of your dream house. But building your dream house? This can be done with a mortgage, but it comes with a twist. Namely, a construction loans.
What is a construction loan?
Construction loans are short-term, higher interest mortgages that pay the cost of building or renovating a house. In installments, the contractor pays the lender a construction loan. After the construction is complete, the home construction loan can be converted to a permanent mortgage or paid in full.
You have the chance to build your dream home. But, it can be difficult to get a construction loan. Before you begin to build, find out how they work and how you can choose the right lender.
Construction loan types
Construction-to-permanent loans
Construction-to-permanent loans convert to a permanent mortgage when building is complete. The interest rates on construction loans with a single closing are known as “single-close”, and they lock in at closing. These loans are ideal if you have a simple construction plan and desire predictable interest rates.
Construction-only loan
Construction-only loans, also called “two-close” construction loans must be paid off once the building is completed. The borrower must be qualified, approved, and pay the closing costs multiple times. You may also be able to get construction loans if you have a large cash reserve or wish to find a permanent lender for the building phase.
Renovation loan
The cost of major renovations is financed with a mortgage and not financed at closing. Instead, renovation construction loans are rolled into the mortgage. The loan amount is determined by the value of the home after repairs and renovations. These loans are useful if you want to purchase a fixer upper but don’t have enough cash for renovations.
What are the terms of a construction loan?
Although every project is unique, construction loans can be used for the following:
- Plans, permits, fees
- Materials and labor
- Closing cost
- In case the project’s costs exceed estimates, contingency reserves are required.
- Interest reserves are a way to save interest on your building project.
What does it take to get a construction loan?
Construction loan
If you borrow money for a home, there isn’t any collateral. This causes lenders to be nervous so you’ll need to go through extra hoops before they give you the money. A thorough inspection of your finances, the architect’s plans, and your builder is expected.
“Inspect the plans of your architect and your builder carefully, as well as your finances. The process of disbursement for a construction loan is different from a traditional loan. Instead of sending a lump sum, lenders pay the home builder construction loans in regular installments. These are called “draws”. Each draw coincides closely with an important phase of your project, such as foundation pouring, framing, and finishing.
Before each draw is released, an inspection is required. The amount of the payment depends on the work done, as detailed in the inspection report.
Home remodel loans
Sean Faries, CEO at Land Gorilla, an software company that helps construction lenders, said that a renovation loan can be used to finance the repair and upgrade costs of your dream house.
Fannie Mae’s HomeStyle Renovation Mortgage, Freddie Mac’s CHOICERenovation Loan, FHA’s 203(k), and USDA’s Single Family Housing Guaranteed loan Program are some examples of common renovation loan programs.
A typical construction loan will allow you to borrow a certain amount for renovations. This is based on the appraiser’s appraisal of the home’s value after repairs and upgrades are completed. The lender must approve your contractor’s plans and pay the money in installments.
There are two things that make a big difference when financing major renovations: a construction loan and a personal loan.
Be prepared for the builder’s review
A mortgage transaction is typically between a lender, a borrower, and a lender. However construction loans add a third party: the builder. Everything depends on the ability of your contractor to complete the construction plans within budget and on time.
“Look at their references and see what other work they have done. Faries recommends that the plans and specifications be approved by the local authority so they are ready to start the project.
A lender may ask for your builder’s work history and proofs of insurance.
What is the down payment needed for a loan construction?
A 20% to 30% downpayment is usually required for new construction. But, there are some programs that allow you to pay less. FHA 203(k), which allows for down payments as low at 3.5%, is an example.
How to get a loan for construction
Like all mortgages, the minimum credit score and maximum debt-to income ratio required to obtain a construction loan vary from one lender to another. These requirements depend on how much money is borrowed.
Lenders will review:
- Your debt-to-income ratio is Most lenders expect your debts not to exceed 45% of what you earn. However, a lower amount is better.
- Credit score Most construction loan lenders require credit scores of 680 or more.
- Downpayment: A down payment of 20% to 30% is usually required for new construction. However some programs may allow for less.
- Repayment plan A construction-only loan might require the lender to determine if the amount will be paid in cash or refinance once the work is finished.
How to choose a loan lender for construction loans
Ray Rodriguez, TD Bank’s regional mortgage sales manager in New York, says that not all mortgage lenders offer a building product. Compare rates and terms between lenders who offer construction products once you’ve found a few. He also suggests getting prequalified before even thinking about blueprints.
Rodriguez recommends getting prequalified before even thinking about blueprints.
Rodriguez said that construction loans are generally underwritten the same way as traditional mortgages. However, “it might take a little longer for closing because there are multiple parties involved and you’re subject to subjective underwriting based upon future value.”
A home building process can take a while and there are many moving parts. Therefore, you need to carefully choose your financing.
