Construction Loans
October 4, 2022
It can be difficult to navigate the process of building a new home or renovating your current one, but if you develop an understanding of how construction loans work, it will help you along the way. A construction loan is a short-term loan – typically for one year – that gives you the ability to build a new home or renovate the one you live in. They usually last for one year because that is the amount of time given to build the home and to receive the certificate of occupancy. According to Miranda Marquit at Bankrate, the lender will need to receive a construction timeline, detailed plans, and a realistic budget to move forward.
Unlike many mortgage products that promise fixed rates, construction loans usually offer a variable rate that is higher and fluctuates with the prime rate. This is because the home typically acts as collateral with a traditional mortgage. When the home has yet to be built, it cannot serve as collateral. Once the home has been completed, construction-to-permanent loans can be converted to traditional mortgages. Typically, with construction-to-permanent loans, it is only expected that borrowers pay interest payments during the construction phase. However, if the loan is only for the construction phase, then a separate mortgage may be needed to pay off the loan.
There are certain things that can and cannot be covered by a construction loan. The most common parts that are covered include the land, contracted labor, building materials, and permits. Appliances and landscaping may also be included depending on the loan provider. However, furnishings and other household items are not typically covered by construction loans.
Kiah Treece and Mike Cetera at Forbes highlight a few things that are often necessary to receive approval for a construction loan. This list includes good to excellent credit, adequate income to pay off the loan, a low debt-to-income ratio, project and construction budget approval, and builder and general contractor approval.
Upon approval of the construction loan, the lender will determine a draft or draw schedule for the borrower that follows the project’s stages. These phases may include major milestones such as the laying of the foundation and the framing of the home. Additionally, it is common for the lender to have an appraiser and/or inspector examine the home throughout each stage of the process – roughly four to six times in total.
The three most common construction loans are construction-to-permanent, construction-only, and renovation. One of the primary benefits of a construction-to-permanent loan is that it only requires one set of closing costs. After it shifts from a construction loan to a traditional mortgage, the loan term is usually 15 to 30 years, and a fixed rate is most often available.
Construction-only loans are almost always more costly than construction-to-permanent loans when a traditional mortgage is needed after construction. This is because there are two sets of fees and closing costs – one for the construction-only loan and another for the traditional mortgage. Another variable to factor in is your financial situation. Could it change between the time you receive a construction-only loan and when a mortgage is needed? It might be difficult to qualify for a mortgage if there is a significant drop in household income during that time period.
Renovation loans come in a variety of options and often depend on the size of the project. Those looking to spend less than $20,000 may want to consider getting a personal loan or a Home Equity Line of Credit (HELOC) to finance the renovation, depending on the amount of equity the homeowner possesses.
As you explore your options, be sure to research all the construction loans mentioned above and think about which one best fits your needs. A trusted lender will be able to walk you through the process and lead you in the right direction.