How Do Construction Loans Work? 8 Important Points to Understand


BY The Lenders Network

how do construction loans work

4 minute read

Everyone has their dream home. But finding that home is harder than it seems.

That’s why many homeowners opt to build their home.

But don’t get too excited just yet. This option is extremely expensive.

Many homeowners can’t afford a newly built house without a loan.

Construction loans help cover the costs of many expenses of home construction.

It’s important you know all of the construction loan details before you sign the dotted line.

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1. The Two Types of Construction Loans

When signing up for a home construction loan, you have two options.

Construction-to-Permanent Loan

This type of loan starts out as a loan to build the house. Once the construction is complete and you’re settled in, the loan becomes a traditional mortgage loan.

This is ideal for many homeowners because you only have one set of closing costs to pay.

Construction-Only Loan

This loan only covers the home’s construction.

If you decide to take a mortgage, you need to sign up for a separate one. For this option, the mortgage can also help pay off the home’s construction. This option is attractive because you don’t need as large of a down payment.

2. Qualifying for a Home Construction Loan Is Difficult

Before you start deciding which home construction loan you want, understand that qualifying for a home construction loan is difficult. This is because providing collateral is difficult.

The home isn’t built yet, therefore a lender can’t use your home as collateral.

In addition, certain home construction projects qualify for a construction loan.

Your acceptance depends on the home’s size, materials used, and the contractors and subcontractors. All of this helps to determine the loan’s monthly payments and if you can make them.

3. Higher Minimum Requirements

This doesn’t mean getting a home construction loan is impossible. You just need to know what to expect.

Here are the requirements.

  • Stable income
  • Good-to-excellent credit
  • 20% down payment
  • Low debt-to-income ratio

The reason for the strict requirements is home construction loans are a bigger risk than general mortgage loans. As mentioned previously, the bank can’t use your home as collateral.

So the lender needs to ensure you can afford the payments plus the interest and any extra and surprise expenses.

The minimum requirements for construction loans are much more stick than traditional mortgages. You must have at least a 20% down payment, and a minimum 640 credit score to qualify.

These loans also come with higher interest rates than other types of mortgages.

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4. Save for Extra Expenses

Just about every home construction project comes with unexpected expenses.

During the first consultation with the contractor, they will give you a base price on your floor plan, materials, and the general contracting wages.

The customization is what will really drive up the price. This includes flooring, paint, and other added details that will make your home your home.

You’ll likely be living in your house for years. It’s a serious investment. Save up a couple extra grand to cover the extra costs. If you go for a larger loan, be sure you can afford the monthly payments.

5. Choose a Home Construction Lender

After you figure out if you qualify for a construction loan and you save up enough money, it’s time to choose a lender. But this is easier said than done. Since construction loans are risky, not all banks and financial institutions offer them.

Here are a few places where you can find construction loan lenders:

  • Certain banks
  • Mortgage lending firms
  • Online lenders
  • Credit Unions

Before you sign up for a loan, look at several different lenders. Submit different applications and view the rates and terms.

6. Choose Your Builder

You should always get pre-approved for your loan before choosing a contractor.

The contractor you use for the project will also be beneficial. They can help gather the required information on the construction and can work with a home in your budget.

But no two contractors are the same. The best contractors have a strong portfolio that consists of homes in your preferred price, style and size.

How do you find a contractor? Your local homebuilder’s association is your best bet. They can provide referrals to reputable contractors in your area.

7. Purchase Land, If Applicable

There are times when you have to purchase land when building your home. If your contractor doesn’t have a lot or you’re building a home outside of their lot, you’ll have to secure a piece of land.

You need to check certain zoning laws and the overall condition of the land. This ensures the land is safe to live on. Fortunately, as long as you live in a major city, most land has been developed and is in livable condition.

The price of your land should be included in your construction budget. There may also be other costs, such as an architect and other maintenance and landscaping factors.

8. Expect Ongoing Inspections

During the home construction process, don’t be surprised if your lender shows up and inspects the construction. This is a normal routine. These inspections are done to ensure the building process is going as planned.

The lender will pay the contractors in stages, also called draws. During each draw, the lender will show up and make sure the contractor is making progress.

They could also hire a professional inspector to do this work.

Every state has different requirements. But expect five different inspections for each draw.

Construction Loan Pros and Cons

Pros

  • Get to build your home just like you want it
  • Can build the home in any location you want
  • Interest only payments during construction
  • Loan for both the loan, and the house
  • Adjustable and fixed rate loan options

Cons

  • Higher interest rates
  • More difficult to qualify for
  • Require a higher down payment than other mortgage types
  • Loan amount may be higher than expected
  • Must pay for an appraisal on the land, and another when the home is completed

The Bottom Line…

Have you always dreamed of living in a newly constructed home? While this dream can become a reality, you need a home construction loan.

But how do construction loans work? They’re riskier and different than mortgages.

The lender can’t use the house as collateral, so the standards are strict. As long as you follow this guide, you can get approved for a construction loan.

Are you looking to speak to a lender about a construction loan?

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