With a lack of inventory in the existing home market, building a home may have crossed your mind as a potential option. If you were to do a quick web search of “construction loans”, you’d find an immense amount of information but when it comes to building a home, the financing involved is just as personal as customizing the home you hope to build.
For starters, let’s discuss some of the basics of new home construction financing.
What is a Construction Loan & How Does It Work?
A construction loan is a short-term loan taken out by the borrower and used to pay for the cost of building a house. Payments, also known as “draws”, are made to the builder throughout the duration of the building process.
Typically, construction loans require interest-only payments during a set short-term construction period (usually a year) and become due upon completion.
After the new home is complete, the borrower acquires a new loan to pay off the construction loan, which is called an “end loan”.
What Do I Need for a Construction Loan?
Construction loans are often referred to as “story loans”, because your lender needs to know the story behind the proposed home before determining whether they are able to finance the construction.
On top of the normal steps of getting approved for a mortgage, if you’re building a home, you’ll also need to provide your lender with plans and specifications of your build, a contractor’s statement, builder contract and end-loan approval.
What Is Construction-to-Permanent Financing?
Some lenders offer construction-to-permanent financing programs where the construction loan is converted into a mortgage loan after a certificate of occupancy is issued, meaning one application and one closing.
Requirements and eligibility include:
- 20% minimum down payment
- Maximum 80% LTV of “as-completed” appraised value or cost of land and house/construction – whichever is less
- Ability to combine with an end loan for a one-time closing
Though a one-time closing may sound ideal, construction-to-permanent financing can limit a borrower’s flexibility, specifically with the amount of the loan, as it is determined up-front and any decisions during the construction that may increase the cost of the home can not be easily added to the loan amount, even if the borrower qualifies for the higher loan amount.
Where Do I Start the Process?
As with any home purchase, the first place to start is with your lender. As previously mentioned, construction financing is contingent on the situation of each borrower and home build. Furthermore, a budget range is extremely important to bring to the table when it’s time to sit down with prospective builders.
Knowing where you stand budget-wise will help you assess and modify your building plans going forward.
For more information about the construction loan process, download our free Rehab & Construction Guide.