How Do Home Construction Loans Work, and What Are the Requirements?

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A construction loan gives a new owner the money they need to build a home. Unlike a standard mortgage, the term on a construction loan only lasts for the amount of time it takes to build the home—usually one year or less. Once the construction is complete, you transition to a mortgage.

Compared to finding a mortgage to buy an existing house, applying for a construction loan presents a number of complications. Requirements include higher credit scores, bigger down payments and proof of a detailed project plan.

How Do Home Construction Loans Work?

If you’re building a home, you're probably already considering a plot of land or a neighborhood that's being developed. Because of this, most construction loans cover the price of the land as well as the cost of construction.

This added complexity means that construction loans come with more lender involvement than standard home loans. Lenders will want to see your plans for building the home, including an estimated schedule and a budget. These plans will help determine how much money you need in the loan.

Once you’ve secured a loan, the lender pays the builder in intervals that follow each phase of construction. The payment frequency is organized into a draw schedule that's decided between you, the lender, and the builder. At each scheduled step, the lender usually checks on the progress of construction before releasing additional funding.

Prior to the completion of construction, you only make interest payments. Repayment of the original loan balance only begins once the home is completed. These loan payments are treated just like the payments for a standard mortgage plan, with monthly payments based on an amortization schedule.

Different Types of Home Construction Loans

There are two main types of construction loans: a stand-alone construction loan and a construction-to-permanent loan. While both types of construction loans often include the cost of the land, this isn't always the case. Make sure you’re aware of what expenses a lender is willing to finance, and what the origination process would be like if you worked with them.

Stand-alone construction loan: If you take a stand-alone loan, you'll eventually need a separate mortgage loan after construction is completed. The lender offers the first loan as an advance for the construction, and you only pay interest during this time. After the house is built, you will pay off the construction debt in the form of a traditional mortgage.

If you can only afford a small down payment, or you own a home now and will be selling later, a stand-alone loan allows you to put more money down after selling. However, you don’t have the option to lock in a mortgage rate while you have the stand-alone loan, so you could end up facing higher rates when it's time to secure a mortgage.

Construction-to-permanent loan: This is a loan that combines the construction loan and standard mortgage, so you don’t have to refinance after construction or go through another closing process. The lender converts the construction loan into a mortgage after construction.

Like any mortgage, you have the option of a fixed-rate or adjustable-rate loan with a term of 15 or 30 years. A construction-to-permanent loan also allows you to lock in a lower interest rate from the beginning. When compared to stand-alone loans, construction-to-permanent loans are the more convenient option, but they usually require 20% or more in down payment.

Home Construction Loan Rates and Requirements

Lenders are wary when it comes to construction loans, so expect to put in more work before you can secure financing for your new home. Construction loans are usually issued by banks rather than mortgage lending companies. Working with your bank can expedite the process of loan approval.

Typical Construction Loan Requirements

  • Credit score of 680
  • Down payment of 20%
  • Construction plan and schedule

You should have a credit score of 680 or higher when you apply for a home construction loan. Since there's no physical house available for collateral with a construction loan, excellent credit is key. Many lenders also require a 20% down payment for a construction loan, and no lender will approve a loan unless they're confident the borrower can make the monthly interest payments during construction.

In addition to a solid credit history and reliable income, the lender will need to know the specifics of your construction project. Before you can secure a loan, you’ll need to offer details such as who will do the work, the size of the house, and the materials you'll use. Work with a general contractor to gather this information before taking it to the bank.

Because of the riskier nature of construction loans, their interest rates usually run slightly higher than those for a standard mortgage. However, that doesn’t mean you can’t find competitive rates. Your credit score, debt-to-income ratio and the location of your new home are all factors that will help you qualify for a lower rate..

If you already own a home, you may be required to sell it prior to applying for a construction loan to build your next house. If you still owe a decent amount on your home and are looking to take on more debt, securing a loan is going to be difficult. A lender will want you to prove that you can afford your monthly interest payments for the construction on the new home while still covering your current bills. If you can't, then you may need to sell your current home and rent until the builders complete your new home.

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