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So, you’ve picked out the perfect plot of land and chosen your dream home design. But! You’re unable to apply for a standard mortgage, as there’s no collateral or home equity! This is where a home construction loan comes in — to help you fund the entire construction. Want to know how to get a construction loan for a home? Read on! 

Building your own house instead of buying an existing one does come with its advantages. You can decide on the exact house layout, the number and kinds of rooms you want, the type of finishes, or even the swimming pool design

However, financing such a major undertaking can be a really expensive affair. In all probability, you’re going to need a loan to cover the construction costs of your custom home. Moreover, applying for a loan in case of a self-build project can be a tad difficult.

Knowing how to get a construction loan for a home is easier when you understand what exactly is a construction loan. 

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What is a home construction loan?

construction loan

A construction loan is a short-term loan to fund building a residential property. Since there’s no equity or collateral, the borrower ends up paying higher-interest rates — significantly more than traditional mortgage rates. 

Fortunately, this construction loan is available to anyone who wants to get their house constructed on a plot they own — either by themselves or through a licensed contractor. The loan term is usually one year. During this time, the property must be built — complete with a certificate of occupancy.

What does a construction loan cover?

Depending on the kind of construction loan you choose, you can use it to cover a lot of costs. These include:

  • Land cost
  • Construction plans, building permits, and fees
  • Labor and material costs
  • Closing costs
  • Contingency reserves to cover sudden, unexpected costs during the construction process
  • Interest reserves in case you don’t want to make interest payments during the construction process

While home furnishings and decor items are generally not covered by a construction loan, you can include permanent fixtures such as appliances and outdoor landscaping.

Keep in mind that your lender should be in the loop regarding the specific costs as that will help them determine your loan-to-value calculation. 

How do you qualify for a home construction loan?

home construction loan

If you want to know how to get a construction loan for a home vis-a-vis getting a mortgage loan, you should know that it entails a little more requirements.

Generally, before a construction loan application, the borrower should’ve finalized the house plans with an accredited architect and negotiated a contract with a builder — with details of the total cost to build the house.

To qualify for a construction loan, you’ll need:

  • Good to excellent credit score. The ideal credit score being 750 or more. 
  • A stable income and employment history
  • Low debt-to-income ratio
  • A minimum down payment of 20 percent to 25 percent

How do construction loans work?

Construction loans usually come with high, variable interest rates that may go up and down with fluctuating prime rates. Lenders view home construction loans as a bigger risk than home loans as there’s no collateral or home equity against the loan.

Since this type of loan depends on the completion of your building project, your lender will require a construction timeline, construction schedule of the stages involved, detailed plans, and a realistic construction budget.

Unlike personal loans whereby you make a lump-sum payment, here, your lender will pay out the money in stages — depending on how the new home is progressing. 

Moreover, the lender may hire an appraiser or inspector to check the house during the different stages of construction. Based on the appraiser’s approval, the lender can make additional payments or draws to the contractor.

What are the types of construction loans?

construction loan types

You can choose any of the following construction loans based on your requirements: 

  • Construction-to-permanent loan

This type of home construction loan provides funds to build your dwelling as well as for your permanent mortgage once the house is complete and ready to move in. Fortunately, you have to pay only one set of closing costs, which reduces your overall fees, including settlement fees.

Once it converts to a permanent mortgage — with a loan term of 15 to 30 years — you may opt for a fixed-rate or adjustable-rate mortgage.

  • Construction-only loan

This loan provides funds just to complete the construction — disbursed depending on the percentage of the work done. The borrower is responsible for paying the loan off when the construction is complete as well as for obtaining a secure mortgage.

A downside is that since you’re making two separate transactions, you end up paying two sets of fees. Furthermore, if your financial situation worsens during the construction process, you might not be able to qualify for a standard mortgage later.

  • Renovation loan 

This loan is only if you want to upgrade your existing home rather than build a new one. If you’re looking to spend more than $25,000 (a lesser amount can be taken care of with a personal loan, 203k loan, or a credit card), you can choose a home equity loan or a home equity line of credit (HELOC) — both come with relatively low-interest rates.

Another good option is a cash-out refinance. Here, you could take out a new mortgage at a higher amount than the current loan and pocket the overage in a lump sum amount. 

Applying for a construction loan to finance a renovation is possible but it’s a thorough process — with the lender evaluating the builder, reviewing the remodeling budget, and overseeing the draw schedule. Basically, they manage the entire process.

Planning a home renovation? Try our free remodel cost estimator. Get estimates in seconds! 

  • Owner-builder construction loan

This loan is specially designed for borrowers who’re also licensed builders by trade, and want to build the house themselves. A lender will allow such a loan only if the homeowner/builder is aware of the complexity of constructing a home, complies with building codes while the home is being built, and has relevant experience.

  • End loan

Once the construction is complete, the borrower will have their permanent mortgage to pay off. This is their end loan.

How to find a good home construction loan lender?

It’s best to find lenders, banks, or credit unions who’re specialists in home construction lending. You need to do your research and check several lenders, their specific programs, and loan procedures. 

Always compare their construction loan rates, loan terms, and the minimum down payment requirements.

Last thoughts

When choosing a construction loan, you need to consider many factors, including whether you want single or multiple closings, the closing costs, total fees, etc. Remember that you need to purchase the land, build a new house, and handle the total cost-efficiently! 

Read more: Understanding Loans: What Home Lenders Should Tell You

Complete Guide on How to Get a Construction Loan for a Home was last modified: October 7th, 2020 by Ramona Sinha
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