This article stems from a reader request via Instagram. If you’re considering leveraging a construction loan to get into your dream home and wondering “What is a home construction loan, and what do I need to know?”, read on.
What Is a Home Construction Loan?
Home construction loans are funds you receive from a lending institution with the purpose of renovating a residential property. It doesn’t have to be for a primary residence. In fact, many people use these loans when they’re flipping houses.
Home construction loans tend to be short-term loans with higher interest rates. Most of these loans only last for 12 months. Builders will use them to cover land, labor, material, and permit costs.
And yes, they can also be used for renovations.
What Construction Loan Types Are Available?
Construction loans tend to fall under two categories. These include a stand-alone loan and a construction-to-permanent loan. Sometimes they include the cost of the land, but that’s not always the case.
Taking a stand-alone loan means you’ll have to take on a separate mortgage once you’ve finished construction. For this type of loan, your lender will offer it as an advance where you only pay interest. Once the project is finished, then you start making payments. However, one of the downsides of this type of loan is if you can’t secure a rate, you could get screwed over with a higher interest rate when it comes time to start making payments.
A construction to permanent loan is a combination of a typical mortgage and your construction loan. (99% of you reading this will do a construction to permanent loan if you’re looking into a construction loan!) Once your project is finished, the loan turns into a typical mortgage. The benefit of this type of loan is that you can lock in a low interest rate. However, you will be expected to provide a down payment.
Need to go FHA for your mortgage? You can roll renovation costs into the mortgage via the 203k loan product. This is what I used to rehab my first home/house hack and I wrote all about the experience here.
How Do Residential Construction Loans Work?
Most construction loans have higher rates than what you’d find in a traditional mortgage.
To get approved for this type of loan, you’ll have to provide your lending institution with details on the construction/renovation of the property. You’ll also have to prove you have qualified builders working on the property (you know, so the bank doesn’t get totally scammed).
Qualifying for a construction loan also tends to require a higher credit score as well. (Here’s how to clean up your credit.) You’ll need to provide your building plans, schedule, and budget, as this allows the lender to define a payment schedule that matches the times you’ll need funds to pay for contractors and materials.
What Is the Underwriting Process Like for a Construction Loan?
When looking for a construction loan, expect to go through an extensive application process. (Although no more rigorous than normal underwriting.) During this process, you’ll need ID, pay stubs, proof of income, tax returns, proof of debt, and other liabilities well documented. Because these loans don’t have a source of collateral, you’ll likely need more thorough documentation than with other types of property loans.
After you’ve been approved, don’t expect to get a lump sum. Instead, you’ll get installments of the loan. These will correspond with important stages in your building process.
You’ll also need to prepare for your lender to do a thorough review of the builder you’ve chosen. They want to make sure the contractor(s) you’ve chosen for the project will carry out their end of the agreement. They’ll need references and proof of past projects, as well as insurance and licensing.
Other qualifications include a debt-to-income ratio of 45% or less, a credit score of 680 or higher, and a detailed repayment plan.
Also, keep in mind that construction loan underwriting can take longer than your typical mortgage because there are more people involved in the process.
How to Choose the Best Lender for a Construction Loan
The best way to choose the right lender for your project is to have a thorough understanding of what you need. What exactly do you need financed? Are you looking to build a home from scratch, or are you renovating an existing property? What kinds of contractors will need to be involved in the process? Do you have some in mind already, and can you speak for their experience?
Before you start construction on your property, you’ll want to get pre-approved by a lender. That way, you won’t budget higher than what you can get financed. However, it’s important to know that not every mortgage lender provides construction loans. (Imagine siren light emojis here — this is very important!)
Typically, you’ll want to work with a local credit union for your construction loan. They tend to have a better handle on the market, as well as what’s involved in construction in your area. Still, even with a credit union, shop around for interest rates and loan terms before committing to one.
When looking for a loan provider, you want an institution that specifically has experience with construction loans. However, if you have an existing relationship with a specific bank, you might consider going with their loan. Since you’ve already done business with them, you can work to negotiate better terms.
- Construction loans are a type of mortgage you take out if you want to build a home or if you’d like to renovate an existing property.
- There are two types: stand alone (for professional builders, usually) and construction to permanent.
- Qualification criteria for a construction loan is higher than a “traditional” mortgage.
- Not every lender offers construction loans. Credit unions might be the way to go.
Lauren Bowling is the creator of Financial Best Life. Writing about money since 2012 (formerly as L Bee and the Money Tree), Bowling is an award-winning blogger and money and real estate expert whose advice has been featured on CNBC, Forbes, CNNMoney, Elite Daily, Business Insider, Redbook, and Woman’s Day Magazine and more. After selling the site to a division of The Motley Fool in 2019, Bowling is now back as the owner and primary voice behind FBL and is excited to continue educating elder millennials everywhere about how to afford their best life.