Home Construction Loans: 4 Facts You May Not Be Aware of

Building a new home is exciting.

Obtaining the loan is not.

But unless you have sufficient funds in the bank to have your home built out of pocket, you will need to obtain a loan. While the process doesn’t have to be overly complicated, there are some things you should know going into the process that will make it less stressful. The first question is:

Can you get a loan to build a house? The answer is yes, and here are 4 things to consider before starting the process.

What is a home construction loan?

A home construction loan can be a short-term instrument whose main purpose is to provide the funding necessary to get your home built, or it can be a loan that pays for the construction process and then converts to a permanent loan at the end of the process. There are many variations available and you’ll need to consider your unique situation when making your final decision.

What are the requirements for a construction loan?

A construction loan is a little trickier to obtain than a standard mortgage and it is easy to understand why. The standard mortgage is offered on an existing home the bank can see and verify the value of. A home construction loan is issued for something that doesn’t exist yet and there is no guarantee to the bank that it will get finished – unless your builder has an excellent reputation in the industry.

As with other home loans, you will need to know how much of a loan you are trying to obtain, but you will also need to know the length of time the builder needs to complete your home, what type of permanent financing you are looking for and whether you want to make interest-only payments or pay on principle as the loan is maturing. An online tool that is available for free and can give you a reasonable snapshot of your financial situation through the building process is a home construction loan calculator. Get one here.

What are some types of home construction loans?

  • Construction to permanent loan

Probably the most popular loan for those having a house built, this loan provides for the funds to build the home and then converts to a permanent loan once the construction process is complete. One of the big advantages of this type of loan is that you only pay one set of closing costs.

  • Construction only loan

This loan only pays for the cost of building the home and is paid in small lump sums, called draws, as the builder completes each phase of the home. Usually good for a year, these loans carry a higher interest rate and the borrower normally only pays the interest on the loan until converting it to a permanent loan once the certificate of occupancy is issued and the home is move-in ready.

There are some things to consider when taking this route. If you lose your job or your income decreases, you may not qualify for the permanent loan when closing comes. Another risk that may arise is the current interest rate for construction-only loans is often tied to the current rate on T-bills and any rate increases in that rate are immediately felt in your payments.

Construction Loan Rates

Home construction loan rates, as with other loans, will be dependent on your credit score, credit history, the value of the property you are building on, and the amount of money put down.

  • Do you have to have a down payment for a construction loan? – Normally, yes. And that amount could be as high as 20% or more.

Another thing to consider: most banks will not finance the property you are building on with the initial loan since raw land rarely has a loan value equal to its retail value – until the home is completed on the property.

How to find a home construction loan provider

Most major banks and credit unions are great resources for construction loans. They have access to government programs such as FHA loans, which have great first-time buyer rates and make qualifying for the loan much easier.

Starting the process

When you prepare to head off to your lending institution for your construction loan, you’ll need to be sure you have the usual paperwork, plus some!

  • Two years of tax returns

  • Proof of current income

  • A deed showing that you own your property (unless your bank will loan you the money on your land)

  • Information on your builder (licensing/insurance/proof of recent homes built and the banks that financed them)

  • Complete set of engineer-approved construction blueprints

Having this information readily available will give you a head start on getting your loan process underway. It’s a good idea to work with your builder when it comes to choosing a lender as the builder should already have banks or other lending institutions that he/she has worked with in the past.

If you have never purchased a home before, another thing to keep in mind is that banks like you to have minimum credit obligations when the loan process begins. The better prepared you are when you sit down with your loan officer, the better your chances of getting approved.

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