Home Construction Loans: Build Your Own Home on the Bank's Dime

By
Industry Observer with LendingTree

If you've been browsing for the home of your dreams to no avail, it may be time to consider building it from scratch. A home construction loan could help your dreams become a reality. Unlike traditional mortgages, construction loans last for as long as it takes to build the home and then (usually) transition into a conventional mortgage once the home is complete.

Applying for a construction loan is more complicated than obtaining a mortgage for an existing house. Nevertheless, securing a construction loan is the first step towards building the home of your dreams.

 

How Does a Construction Loan Function?

Construction loans usually cover both the cost of building the home and the underlying land on which it's developed. The lenders of construction loans will typically take a greater interest in your purchase than they do on a conventional mortgage. The lender will want to see the blueprints for the project, as well as the estimated budget and schedule for the construction. These factors will all influence how much the lender is willing to provide.

If you manage to secure a construction loan, the bank will proceed to pay your builder in intervals that span each phase of construction. Every building project will usually correspond with a draw schedule that's decided with input from you, the lender and the contractor. Each step along the way, the lender will usually keep abreast of your home's progress before disbursing the next payment. 

You will usually only be required to make interest payments during the construction phase of your loan. This changes once construction is complete, during which the loan payments are then converted into a traditional amortizing mortgage structure. At this phase, you will begin making fixed interest and principal payments over time.

 

What Kind of Construction Loans Are Out There?

Stand-alone and construction-to-permanent loans are the two variants of construction loans that will typically be available to aspiring home builders. While both types of loans usually include the cost of land, this isn't always the case, so you'll want to ascertain which expenses a lender is willing to cover under your loan agreement. 

 

Stand-Alone Construction Loans will require you to obtain a separate mortgage once the building is complete. Standalone loans usually act as an advance for the construction project, and mandate interest-only payments during this phase. Once construction is complete, you will need to pay off the construction debt using a traditional mortgage.

Stand-alone construction loans are a good option if you can only afford a small down payment upfront, or if you're still making payments on an existing property that you already own. These loans allow the opportunity to make smaller payments up front, so you can save money for a down payment once you're ready to obtain a conventional mortgage.

Keep in mind that this can be a double-edged sword, especially if mortgage rates continue to rise during the construction phase of your home. A stand-alone construction loan won't let you lock in your mortgage rate today, so you might face higher rates by the time your new home is finished.

 

Construction-to-Permanent Loans combine both construction loan and mortgage, avoiding the need to refinance once construction is complete. These loans automatically convert into a mortgage once construction is complete.

Construction-to-Permanent loans behave like typical mortgages, and offer common terms like fixed-rates and adjustable rates for 30 or 15 years. Compared to a stand-alone construction loan, construction to permanent loans offer a more convenient option at the expense of a higher down payment.

 

Rules to Follow When Obtaining a Construction Loan

Expect to put more work towards obtaining a construction loan than a traditional mortgage. Due to their specialized nature, construction loans are usually only available through banks rather than mortgage lending companies, which limits the number of options at your disposal. 

The typical requirements for a construction loan include a credit score of 680 or higher; a minimum down payment of 20%; and a cohesive construction plan, schedule, and most importantly, budget. 

Any lender willing to supply a construction loan will need to know the specifics of your plan. Be ready to supply details like the names and resumes of the contractors working on your home, the anticipated size of the property, and even the materials you plan to construct it with. General contractors will be able to compile this information for you. 

Construction loans are usually seen as riskier than standard mortgages, as there's always a chance the project will run over budget. The bank also lacks any substantive collateral to secure its interests, given that the home doesn't technically exist when the proceeds are disbursed.

You can therefore expect to be penalized on the interest rate relative to a standard mortgage. However, this doesn't mean that competitive rates aren't available. Maximize your credit score; minimize your debt-to-income ratio; and find the best location for your new construction project to maximize the probability of obtaining a lower rate for your loan.

 

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