Buying a house is an expensive and risky task, but building your own home is an even more tremendous undertaking. It entails an exhaustive list of tasks, such as finding the right architect, securing permits, dealing with labor, and projecting your expenses and mortgage payments. It is a financial and mental burden, but the good news is that this financial burden can be alleviated with the help of a construction loan.
Construction loans are specifically designed to help the borrowers with projects, whether it is building a house from scratch or renovating an existing structure. However, it is crucial that you first develop a deep understanding of what precisely a construction loan is and what its demands are.
Defining A Construction Loan
This type of loan is used to finance the construction of a commercial or residential property. It starts as a short, high-interest loan while the work is being completed and then transitions into a mortgage once the project is finished. Construction loans mainly cover the cost of land, labor, building material, and permits.
How Do They Work?
Construction loans have variable and higher rates than conventional mortgage rates. Typically, with a conventional mortgage, your home is at stake and can be seized by the lender in case of defaulted payments. With construction loans, the lender does not have this option; therefore, these loans are viewed as high-risk loans.
Construction loans are short-term, usually one year long, and depend on the project’s completion. Due to this, you need to provide the lender with a detailed account that includes the construction timeline, plans, and a realistic budget. With a good credit score, getting approval won’t be difficult, but it is essential to remember that your contractor also needs to be approved by the lender to ensure that they will be able to complete the project in time.
After the loan is approved, the borrower will be given a payment schedule that is in line with the project’s construction phase, and they will only be paying the interest during this time. Construction loan lenders give out the loan amount in parts as the work progresses rather than giving out a consolidated amount.
These payments are made when significant milestones are completed, like laying the foundation. To check the progress, the lenders send out inspectors during the different stages. They might employ the help of a construction loan management company, like Northwest Construction Control, to help mitigate risks and keep a close eye on the project.
Construction Loan Types
There Are Five Types Of Construction Loans:
Construction-To-Permanent Loan
This loan funds the construction of a home. Once the construction is completed, the loan gets transformed into a fixed mortgage. This is best for homeowners that want to save on loan closing costs and lack mortgage financing to borrow collateral loans.
Construction-Only Loan
This is a short-term, variable rate loan that is used to conclude the construction of a project. Once the building process is complete, the loan must be paid in full or refinanced into a mortgage. Borrowers who already have a significant sum of money required for the construction or those who intend to pay with the sale of a previous property opt for this loan. However, these can ultimately be costlier if you need a mortgage because this requires two separate loan transactions and two payment sets.
Owner-Builder Loan
These loan draws are directly made to the owner builder rather than a third-party contractor. The owner acts as their own general contractor. Owner-building loans are exclusively available to homeowners that can prove that they have experience in construction or have a construction license and the expertise required to comply with building codes.
Renovation Loan
This option is the most similar to a traditional mortgage. A renovation loan covers the cost of purchasing a home and carrying out major renovations. Due to this, the loan amount depends on the predicted value of the property after renovations. Those who buy houses intending to flip them with intensive renovations apply for this loan. Another option is a cash-out refinance, in which a homeowner would take out a new mortgage at a higher amount than their existing loan and receive that surplus in a lump sum amount.
End Loans
These refer to the homeowner’s mortgage after the construction is concluded. A construction loan is paid once the building is constructed, and then you will just be left with your regular mortgage to pay off.
How To Secure A Construction Loan
Construction loans are considered high-risk loans as they are unsecured. This is why the process is more detailed than an average mortgage loan. To reduce associated risks, lenders need the borrowers to have a high credit score. If you are considering applying, try enhancing your score to maximize your chances of securing the loan. Along with a solid credit score, you also need to have a sufficient income to deal with subsequent payments. You will need to provide your lender with documentation regarding the cash flow in your bank account.
The lender will also calculate the borrower’s debt-to-income ratio. A low DTI indicates that you have more disposable income for your loan repayments. Alongside, the lender will require a detailed account of your budget and plans and the approval of your contractor. You will need to make a downpayment of at least 20%; however, many lenders require between 25% to 30%.
It’s in your best interests to cross-examine several construction loan lenders to get details about their specific programs and procedures. Compare their construction loan rates, terms, and down payment requirements to ensure you’re getting the most suitable deal for your situation. If you’re facing difficulty in finding a lender that is willing to work with you, then you can try reaching out to credit unions and smaller regional banks as they are more flexible with their requirements.
Endnote
Construction is a cost-intensive project, and very few can do it without additional financial assistance. A construction loan is a convenient solution to acquire the funds needed for land, labor, material, and other building-related expenses. First, you must thoroughly understand what this entails and the kind of loan your specific project requires. Once you have acquired the loan, it’s best to proceed with a construction management company to ensure you spend the secured funds correctly. Otherwise, amateur construction attempts will merely make your money go to waste.
