What to do when seeking a home-construction loan
Tips for getting a construction loan
- Shop around. Banks may offer only one type of construction loan.
- Get pre-approval. Determine how much the lender will loan you.
- Develop construction plans and estimate costs. You may want to work with a certified builder.
- Obtain a final loan approval. Sell the lender on the "story" of the loan.
Construction loans are completely different from standard mortgages. Instead of financing the purchase of an existing home over 15 or 30 years at a low interest rate, you are financing the construction costs over the time needed to build a new home — typically a single year — at a much higher interest rate than a traditional mortgage. That rate can be as high as 8 to 9 percent, and the loan must be paid off completely when you take possession of the home — usually by getting a standard mortgage.
How does a construction loan work?
During construction, you only need to make monthly interest payments on the loan, and those payments are based on the funds that have been drawn for use on construction at that point in the schedule. So, in the early months, your interest-only payments may be quite low, but they will build as work proceeds and more money gets drawn out to pay costs. Think of the construction loan as a large credit card with a hard limit, and you are paying the minimum every month to cover just the interest.
It also is possible to roll the interest payments into the loan itself, allowing you to avoid making any payments on the loan while the house is being built. This can be a boon if you have another mortgage or rent payments. You must then pay off the entire loan plus the interest costs once you take possession of the house.
How to find and secure a construction loan
To get started on a construction loan, you will want to shop around for a bank or mortgage company that does construction loans. Unlike standard mortgages, where a lender may have many different loan programs to offer, construction loans are a small niche with fewer loan types. You may have to talk to several different banks or mortgage companies to find all the deals available to you.
At this point, you are simply looking for pre-approval on a loan amount based on the same factors that would come into play for a standard mortgage — income, assets, debt load, credit rating and equity or down payment. Most lenders will want you to have a 20 percent stake in the loan. They will provide 80 percent of the cost of the construction, for example, and you will need to cover the other 20 percent. This is your "skin in the game." If you already own the vacant land, you can use that equity as part of your down payment.
Once you know how much your bank or mortgage company is willing to lend you for construction costs, you can start planning the house. Finding a reputable builder is the best way to proceed at this point. You can do the work yourself, but some lenders may require a certified builder to be attached to the project before they provide final approval. Working with a builder also eases other headaches down the road — like filing for permits, providing insurance for workers on the job and getting through inspections.
Before you go back to the lender for final construction loan approval, you will need the following:
- A parcel of land picked out or purchased;
- A list of all building materials needed for the project and their costs;
- A list of all amenities for the house — such as appliances, specialty countertops, etc. — and their costs, and;
- A construction schedule.
You also will need an appraisal of what the house will be worth when completed, which will be based on the plans, materials, amenities and the neighborhood you picked out. The lender will want to see just how the loan funds will be spent and assure that the house will be worth the investment when finished.
Remember, there is no actual house at this point for collateral, so you must sell the lender on "the story" of the loan to get that final approval.