For many people, building their dream home is a dream come true. If you want to make this dream a reality, chances are good that you will have to build a home with a home loan.
If you are interested in building your own home, here’s what you need to know about home loans and how they work.
What is a construction loan?
A home loan is what it sounds like – a loan designed to help you build your home from the ground up. However, it is important to note that a construction loan is not a long-term loan for up to 30 years, but rather covers the period when your home is under construction. Most home loans have maturities of a year or less. Once the home is completed, you must pay off the building loan or get another, larger loan (actual mortgage) to pay off the cost of the building.
Your home loan will include the following expenses:
- Land for home
- Labor and materials needed to build a house
- Fees, permits and any plans
- Provisions for contingencies to cover contingencies
- Interest reserves for those who do not pay interest during construction
- Closing costs
It is important to note that a building loan is often more difficult to obtain than a regular mortgage, so you need to be prepared to overcome several challenges.
How to get a construction loan?
Many home loans come with higher interest rates than what you would see with a standard mortgage. Also, depending on your situation, you may need to sell your current home before proceeding with a home loan.
In general, if you want to qualify for a construction loan, you can expect to provide the following:
- Initial payment of at least 20%: While you can usually pay less for the down payment on a regular mortgage, many lenders do not accept less than 20% on a building loan because the home has not yet been built, which means more risk.
- Higher credit rating: While some mortgage lenders offer loans to those with a score of 620 (and sometimes less), many home loans require you to have a higher score, sometimes at least 680, to even qualify.
- Stable income: To get a home loan, you need to have a stable income, but this is necessary for a home loan.
- Debt to income ratio: Many lenders are stricter on this requirement for home loans than for more traditional mortgages. The upper limit is usually 45%, but you may need a lower ratio.
- Construction plan and schedule: You need to provide a planned construction schedule. Lenders require that you have a plan and schedule that makes sense to complete the project.
- Builder Review: You also need to keep in mind the builder for the project. The lender can check the builder’s qualifications and previous work, as well as check the condition of your home.
Before contacting a potential lender for money, you need to have all of these elements in place.
Types of construction loans
When deciding on a construction loan, think about the different types of loans. Think about your long-term needs as you move forward.
Permanent building loans
This loan is probably the easiest type of loan to manage as it completes the construction of your home and then converts your construction loan into a mortgage when the construction phase is completed. These loans are sometimes referred to as “one-off closing” loans. You fix the interest rate at the start of the project and carry it over for the entire duration of the mortgage. If you have a simple building plan and want to convert it into a mortgage when the house is completed without getting another loan later, a pre-permanent building loan may be a good choice.
Loans for construction only
Be that as it may, the construction loan only covers the construction period. You will have to close two different loans. First you have to get a building loan and then you have to close the mortgage. If you have large cash reserves, you may be able to get this to work. Plus, if you want to look for a lender and potentially get a higher interest rate later, a construction-only loan might work. Just be prepared with different funding to pay off your construction-only loan on time.
Resource: How to find the best mortgage rates
Loans for repairs and construction
If the home you are dealing with needs a major refurbishment, you can get a building loan to help you cover those costs. This loan can be an option if you buy a top fixer instead of building a house from scratch. After a major overhaul, you may need a larger down payment. You may also need to provide a construction plan and schedule because your loan will be based on the projected value of the home after you complete your renovation.
Banks offering construction loans
Not every bank offers construction loans. If you are hoping to build or renovate a home, you need to look for a lender that provides this type of financing.
- TD Bank: Offers flexibility with a variety of options including one-time closing loans.
- Nationwide Home Loans Group: Provides a variety of options, including a lower credit rating.
- BB&T Bank: various types of loans, including for construction and permanent storage.
- VA National Housing Loans: Offers the option to use VA benefits to fund construction loans.
Prepare all your documentation ahead of time. Also, be prepared for regular inspections and ongoing permits during the construction process. Knowing the requirements can help you get a construction loan permit.
FAQs
Bottom line
Obtaining a construction loan is a complex process that can take a lot of time and effort. Before applying for one of these, be sure to read the section above which details how to qualify. Then collect all the necessary documentation ahead of time. The more you prepare in advance, the easier it will be to avoid surprises.