Construction loans: What do you need to know?
Construction loan basics
- Construction loans are short term, typically no more than 12 months
- They carry heavy risk for the lender because there’s no collateral to borrow against
- Borrowers and/or contractors draw money as they need it and only pay interest on what they draw
The time seems right to purchase your dream home. The first step is to decide whether to buy an existing home or build a new one.
In the latter case, a buyer will need some form of a construction loan. The key concept of construction loans is they differ from traditional mortgages. Rather than paying back the loan over many years, you'll have a short time frame – generally 12 months or less – to pay the construction loan. This is generally done by rolling this debt into a more typical mortgage loan.
With a traditional mortgage, a lender will let you borrow based only on the value of the existing property. But construction loans let you borrow based on the estimated property value after improvements, such as the home and landscaping.
Building a new home
Depending on whether you're using a general contractor or a custom builder, some of the steps below may not apply. It can be a long and complicated process to build something from scratch. To start, you must figure out how much home you can afford.
New home construction carries more risk for a lender since the structure isn't yet a tangible piece of property. Construction loans are often much harder to find and obtain than standard mortgages. Regional and local banks or credit unions know the local marketplace and are more likely to offer them. Most lenders will factor the costs of land acquisition into the total loan amount.
Lenders may guide you through a prequalification phase, where they review your basic finances to determine your borrowing capacity. They'll provide borrowers with a preapproval letter that comes in handy when meeting with potential builders so that builders know your price limit up front.
If you already own a home with an existing mortgage, the next step can be challenging. Many lenders won't approve loans with a high income-to-debt ratio, so you may need to sell your home before building a new one. There are options to mitigate the timing of a move, including a bridge loan or home equity loan, that lenders are likely to approve once they see a binding sales agreement.
- One-step loans (also known as construction-to-permanent loans): You're essentially closing the construction and mortgage loans simultaneously with the same lender once construction is completed. The amount borrowed during construction is rolled into the permanent mortgage. These loans are best when a borrower doesn't expect a construction timeline to change.
- Two-step loans: This is a better choice for custom homebuilding, as they offer more flexible terms. It's easier to modify plans or increase the loan during the construction process, for example. Think of it as refinancing with two sets of closing costs. You can shop around for better rates: Two-step borrowers do not have to take a new mortgage from the same lender who provided the construction loan.
Closing the loan
Once you start the loan application process, you'll need: a deed or purchase offer on the land that outlines any covenants or restrictions; the responsibilities of the builder and, if needed, an architect; the builder's resume, proof of insurance and credit references; blueprints and building specifications; line-item budgets; and a draw schedule to show the amount and frequency of loan withdrawals.
At closing, you'll need to make the downpayment and closing costs. Many lenders will want 20 percent to 25 percent up front. For example, consider a home with an expected worth of $200,000 built on land worth $80,000. If the lender wants a 20 percent down payment, you'd pay 20 percent of the $280,000 estimated value ($56,000) and your permanent loan would be $224,000.
Lenders often use a prime-plus rate for construction loan interest, which can be up to 2 or 3 points above the prime lending rate.
Once you select a location for the new home, check the local zoning codes. They vary from area to area, but in general, they exist to make sure new construction blends in with surroundings. Zoning codes can usually be found online or at local city halls or courthouses.
Zoning laws concern factors such as the height and overall size of a building, proximity to other structures, lot size, distance from roads and water sources, landscaping and fencing.
New home construction funds are not paid in lump sums but in draws across the life of the construction process, typically six to 12 months. The lender will often send an inspector to the site to ensure sufficient progress is being made. They'll also want to know the work is meeting local building codes and regulations.
The loan draw details are often negotiable but a typical pattern starts with 15 percent for site preparation and foundation work, 15 percent to 20 percent for framing, then additional draws of 15 percent to 20 percent for plumbing, electrical work, interior carpentry and appliance installation. Most construction loans are interest-only, so you only pay interest on whatever you draw.