Do you know what home you want to build but aren’t sure how to get the funds to make it a reality? Financing a new home construction can be intimidating. You need a large sum of money, and you need to coordinate with realtors, builders, and financial institutions.
If you are asking, “Where do I start?” and “Can I afford this?”, this article will break down everything from what a construction loan is, types of construction loans, details on how construction loans work, the steps to apply for a construction loan etc. By the end, you will understand how to finance new construction so you can decide if it’s the right choice for you.
Let’s get started!
How Construction Loans Provide New Home Financing
A construction loan is a short-term loan issued by a financial institution for building a new home. It is similar to a line of credit. You get approved for a set amount and draw out money as the construction progresses. You are only charged monthly interest on the money you have withdrawn. When the construction finishes, you owe a balloon payment for the total cost.
You might be wondering, how am I going to pay off the cost of building my entire house within one year?
You have two options.
Types of Construction Financing
After your new home is finished, you will need to get a more traditional type of loan, such as a 30-year mortgage. This new loan will pay off the construction loan, and then normal payments will start.
Two large loans within one year might sound overwhelming. However, there are two options to choose from.
One-Time Close Loans
The first option is a one-time close loan. This is also known as an ‘all-in-one’ or ‘construction-to-permanent.’ It combines both a construction loan and a standard mortgage into one deal. At the time of signing, a maximum mortgage rate is set. As soon as construction ends, your loan converts into a long-term standard loan. The new loan pays off the outstanding balance, and you begin to pay on your standard loan.
Let’s look at the pros and cons of this type of loan option.
Compare the pros and cons to make a better decision.
- There is only one set of closing costs.
- It’s convenient.
- The loan is for both permanent as well as construction financing.
- You can choose from many permanent financing options such as fixed, or various adjustable rate mortgages (ARMs).
- Terms are difficult to change if the design, costs, or schedule changes.
- Permanent interest rates are often higher than other loan options.
- Often you’ll get a higher rate for the construction loan.
So this loan is more convenient because you don’t have to worry about getting a standard loan when the construction finishes. However, it is usually more expensive in the long run and less flexible if you need to make changes during the building phase.
Two-Time Close Loans
The second option is a two-time close loan. You will get a loan for the construction, and then you will get another standard loan for the mortgage. Take note, once construction is complete, you are in fact refinancing the mortgage. This means you will need to reapply to get approved for the loan and you must pay closing costs again.
Here are the pros and cons of this type of loan option.
Compare the pros and cons to make a better decision.
- Flexibility if you need to make changes throughout the project.
- You will have lower mortgage rates than those associated with one-time-close loans.
- You can shop around for the best deal on the permanent financing option.
- Not only do you need approval for the two different loans, but you will also pay closing costs twice as well.
- Your permanent financing option isn’t guaranteed.
- You could face foreclosure if you cannot get approval for permanent financing.
This option provides you the opportunity for a better deal on the standard loan. On the other hand, you have two closing costs and the risk of not getting the second loan.
Now, which option should you choose?
Well, every situation is unique. You may want the security and assurance of the one-time loan or may prefer to get the best possible rates by choosing the two-time close. It’s your call.
Details You Need to Know About Construction Loans
You may have lots of question at this point such as, “how much of the costs will the construction loan cover” and “how will the payments be disbursed?” We’ll answer these questions and more in this section.
With construction loans, the financial institution will approve financing for 75%-80% of the appraised value of completed costs, on average. It is up to you to put down the remaining amount.
If you do own or have equity in other properties, it’s possible to get 100% financing with a cross lien. Similarly, any land you may own can also count as equity. If none of these options are available, you will have to come up with the down payment.
Why do you have to put a down payment? Lenders are taking a risk because the loan is unsecured. Returns depend on the builder executing their end of the deal. So, most lenders will require you to have skin in the game and place a down payment to reduce their risk in case of default.
As we discussed earlier, construction loans are divided into stages determined by the progress of construction.. The lender releases money at each stage, as the home is gradually built. This helps to lower the risk for the lender.
The stages, number of draws, and amounts needed will be negotiated between the builder, the buyer (you), and the lender. Most lenders will inspect the project after each stage to confirm all requirements are met before any money is released. It’s important to note that, unless you secure a 100% construction loan, the first draws will usually be financed by you.
As you can see, a construction loan is simply a big line of credit. More money is disbursed to suppliers and subcontractors as each stage of the construction is completed. The loan balance and interest continue to climb as the work is completed until the final balance is due on the completion of the project.
Let’s take a look at an example of how draws are often disbursed during a construction loan.
- 40% when they finish the foundation
- 20% when they complete the exterior
- 20% when they complete the interior including dry walling, electricity and plumbing installations.
- 20% on certification of completion.
Interest and Fees
As we mentioned above, with construction loans, you usually only pay the interest on the money borrowed and only on the amount that has been drawn so far. Then, when construction is completed, the principal loan and fees are paid off. Regarding lending fees, be prepared to pay between 1% to 3%.
You can also opt for an interest reserve from many lenders. This feature means you won’t have to make any payments during the construction phase of your project. Although payments are due each month, the amount accrued will get paid out of the construction loan itself.
Steps to Get a Construction Loan
If you are ready to charge ahead, here’s what you need to do.
Step 1: Select a Builder
Choosing your builder is going to determine the value of your home. It is the biggest investment most people make in their lives, so make your decision carefully. Here are a few tips from the National Association of Home Builders:
- Shop around for builders (ask your local HBA, real estate agents, and your potential lending institutions)
- Make a list of potential builders.
- Research the builders in depth.
- Look for a balance of quality and value.
Step 2: Select a Lender
Finding the right lender is the next step. Most banks, as well as some credit unions, offer construction loans as part of their lending portfolio. You can also opt for online lenders who specialize in mortgages. Where banks may shy away from a loan due to a low-profit margin, other lenders will jump in.
Quicken Loans, for one, is the second largest retail home mortgage lender in the U.S. They offer a wide range of loan types at competitive rates. Blackhawk Investment Corp. is another interesting option, specializing in secured real estate loans through peer to peer lending. Where banks may turn you down, Blackhawk can be a viable option. These are just a few of your many options.
Don’t forget to talk to your builder, too. Many custom builders already have relationships with lenders or other private funding and use them to secure work. As a result, the construction loan packages are often very competitive.
Find a very experienced construction loan broker; they are a slightly different breed from typical mortgage loan officers because they specialize in this area.
Sidney Potter, owner of Potter Equities and author of ‘The Flip
This way, you can get someone who is focused on getting you the best deal with the specific loan product you need.
At the end of the day, make sure you shop around to find the best loan. You’ll find different rates and promotions from each lender. Don’t jump at the first loan you find and don’t limit your shopping to traditional lenders like banks, check out all available options and compare them.
Step 3: Prepare your Credit
(Prepping your credit) is going to result in a much more attractive interest rate and terms that you will get from the lender.
-D. Sidney Potter
Preparing your credit and getting everything in order before you apply for a construction loan is a must. First, you should maximize your credit score. Here are 15 expert tips as well as advice from MyFico on how to do so. Potter commented on this aspect as well with a warning,
When you are ready to pre-qualify, don’t go out and buy big-ticket items. Don’t buy that Cadillac, don’t buy that boat. Keep it very tight, keep it very prudent as lenders will be looking at that in terms of the underwriting perspective.
Applying for several lines of credit in a short period is going to trigger red flags. Instead, stay focused on the construction loan and ensure your credit report is in order.
Step 4: Get Pre-Approved
Getting pre-approved before you start any construction project is paramount. It not only helps you find out how much you can borrow but then allows you to design your new construction within your budget. It is important to note that pre-approval times can differ. They often last between 30 to 90 days.
There are three factors that all lenders will look at before giving you pre-approval. These are:
- Your FICO credit score.
- Income-to-debt-ratio (the portion of your income used to pay off debts).
- The equity you will be putting into the construction (most lenders only give 75% of the project costs)
Step 5: Apply for the Loan
Once you have followed all the steps above and have chosen your builder and lender, it’s time to apply for your loan. To make the process run smoothly, make sure you have the following prepared:
- A lot purchase contract or your offer to purchase. This should include cost, physical address, as well as location.
- Completed house plans that are finalized and approved.
- A cost breakdown from your builder including specifications such as a materials list and a line item budget.
- Insurance certificates, credit and banking references, and a resume from your builder.
- The draw schedule for the construction project.
- Proof of insurance including course of construction, workman’s compensation and general liability.
- Details of the down payment.
- Completed loan application forms.
With all of these ready and in order, send in your application.
By following these steps, you can be on your way to financing your new home construction! While it might seem overwhelming at first, construction loans are the most popular option. Remember the following:
- Weigh the pros and cons of both loan types to decide which is best for your situation.
- Take note of the details about how construction loans work including interest, draws, and fees.
- Do your due diligence in choosing a builder.
- Shop around to find a lender
- Prepare your credit report and credit score.
- Get pre-approved for the loan.
- Ensure you have everything you need to apply for the loan.
Once you have done all your prep work, just wait for the green light to get your project underway. Ready to start your research now? Head over to our home loan reviews page for an extensive list of loan companies, rates, and plans with real user ratings and reviews.
Jessica Walrack is a personal finance writer at SuperMoney, The Simple Dollar, Interest.com, Commonbond, Bankrate, NextAdvisor, Guardian, Personalloans.org and many others. She specializes in taking personal finance topics like loans, credit cards, and budgeting, and making them accessible and fun.