How does a construction loan work?
A construction loan is designed to cover the cost of new construction. Typically, a lender will distribute the construction loan in installments throughout the project so you have access to funds as you proceed.
Construction loans are quite different from traditional mortgages. Unlike a conventional loan, construction loans are specialty forms of financing designed for the short-term, usually with a loan term of just a year.
Lenders often regard construction loans as riskier than other types of financing. That’s why most of these loans come with higher interest rates than a traditional mortgage.
On the other hand, lenders will often allow you to make interest-only payments during the construction phase, then repay the loan or convert it to a mortgage once the construction is completed.
Types of construction loans
You’ll need to choose a construction loan that fits your needs. Some loans are devoted exclusively to renovation projects, while others cover construction costs for a new building. These can be further categorized into one-time close loans or loans that require you to take out a separate mortgage once construction is completed.
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Construction-to-permanent loans
In a construction-to-permanent loan, you’ll fund the construction project, and then the loan will convert to a permanent mortgage once the construction project is complete. During the construction phase, you’ll only make monthly payments on the interest of the loan.
The advantage is that homeowners only pay one set of closing costs since the construction and mortgage costs are all part of the same loan. And because you lock in your mortgage interest rate at the time you take out the loan, you’re protected from interest rate fluctuations during the construction phase.
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Stand-alone construction loans
Stand-alone construction loans are designed to cover the cost of construction only. These loans are normally dispersed in installments during the construction phase. Once the loan term expires, borrowers must either pay off the loan or take out a new mortgage.
A benefit of this plan is that it only requires you to pay interest on the money you actually use from these installments. However, a stand-alone loan will require you to secure a mortgage once construction is complete.
This means that you’ll pay two sets of closing costs, and you’ll have to meet the eligibility requirements of both sets of loans in order to secure your final mortgage. If your financial situation changes during the construction phase, it could jeopardize your ability to qualify for a permanent mortgage.
How to qualify for a construction loan
Do you qualify for a construction loan? Construction loan requirements and eligibility criteria can vary between lenders, but borrowers can generally expect the loan to depend on the following criteria.
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Strong personal finances
Lenders will usually start by looking at your personal finances. This includes your:
- Credit score: Some lenders may expect a score of 620 or better
- Debt-to-income ratio: Lenders prefer borrowers with a DTI of 43%
- Monthly income: You’ll need to provide proof of income to repay the loan
- Depending on your exact loan type, you may be expected to provide a down payment. Not all loan plans require a down payment, but some lenders may expect a down payment ranging from 5% to 20%.
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A construction plan
Before a lender approves the loan, they will ask to see a construction plan. This includes:
- A signed contract
- Blueprints
- A line-item budget
- Payment schedule
This ensures that the loan you receive aligns with your goals for building/renovating the home. It also ensures that you’re able to cover the cost of your builder’s requirements.
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An approved home builder
Lenders will also want to make sure that your general contractor is licensed and insured before approving the loan. Some loan types may require further approval.
Not sure where to start? You may want to search contractors using the national database, which covers the National Association of Home Builders and can connect you with builders in your area.
The application process
Are you ready to apply for a construction loan? Here are some steps that you can take to streamline the application process.
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Gather your documents
Start by gathering your most important financial documents, such as:
- Recent pay stubs (or other proof of income)
- W-2 tax forms from the last two years
- Tax returns from the last two years
- Bank statements from at least two of the most recent months
- Recent statements of other assets (brokerage accounts, retirement, etc.)
It also never hurts to check your credit score for errors or inaccuracies that could affect your eligibility. Each of the three consumer credit bureaus will allow you to view your credit report for free once each year.
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Secure an approved builder
Gather estimates from licensed contractors. Your lender will want to see construction plans before approving the loan. Getting estimates from multiple contractors will help you find an affordable, reputable builder.
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Apply for the construction loan
Once you’re ready to apply for the loan, you’ll go through the lender’s application process and provide the documents listed above. Your lender will also evaluate information that might include:
- Your construction contract
- Your builder’s financial statements, licenses, and insurance
- A land survey where the home will be built
- The title policy of the land when purchased
During the underwriting process, watch for communication from your lender. They may be seeking additional information that can expedite the approval process.
Managing your construction loan
Once you receive approval for a construction loan, you’re ready to get to work. But don’t forget to manage your loan. Managing your loan will depend on how your construction loan is structured. You’ll first need to cover closing costs, then repay the loan based on the terms of the loan itself.
Some borrowers will repay the loan during the construction phase. Other borrowers will only be responsible for interest payments until the construction is complete. If you take out a separate loan to serve as your home mortgage, be prepared to pay a secondary set of closing costs to finalize your purchase.
Pitfalls to avoid
Construction loans have clear advantages for builders and renovators. However, it’s important to avoid common pitfalls during the lending and construction process. Here are some of the most common.
- Not establishing a clear construction timeline or being prepared for delays
- Not managing your finances during construction to remain eligible for a mortgage
- Failing to complete construction plans before applying for a loan
- Forgetting to save money for a second set of closing costs (depending on loan type)
Taking time to align your construction goals with your lending options can prevent costly snags or other setbacks. It also helps create a seamless process from planning to construction and beyond, providing you with loan payments that align with your budget.
Finding the ideal construction loan
Finding the ideal construction loan depends on your goals and your financial outlook. However, many homebuyers discover that construction financing makes it easier to purchase and improve a fixer-upper, which can save them money in the long term.
Whatever your goals, a construction loan can put the property of your dreams within easier reach and help you build a home to your unique specifications.
