Very few people have the cash on hand that is required to fund the construction of a new home. This is why builders, buyers and investors turn to construction loans to finance new builds they couldn’t otherwise afford. But what exactly is a construction loan?
The simplest explanation is that construction loans are designed to cover the cost of rehabbing or building a new construction project. They are generally shorter in term and higher in interest than a traditional mortgage. And where a traditional home loan is based on the fair market value of the home, a construction loan is based on the projected value of the completed work.
What Are the Main Types of Construction Loans?
There are several different types of construction loans, but there are three that stand out as the most common.
- One-Time Close Construction Loans: The idea behind these loans is to wrap your construction costs and mortgage up into a single package. Your lender pays the builder as the work is completed, and those costs are transferred to your mortgage at closing. It allows you to lock in your rates at closing, and they’re great for people who already have construction plans and timelines ready to go. This is also known as a construction-to-permanent loan.
- Construction-Only Loans: In a nutshell, this type of loan covers the cost of construction — and only the cost of construction. They must be paid off in full when the construction job is done. They’re a great option if you have a lot of capital available, or if you have a home for sale and you’re confident its proceeds will cover the costs. Of course, if you need a mortgage, you’ll have to find another lender and go through the approval and closing process all over again. This type of loan is also known as a stand-alone construction loan.
- Renovation Construction Loans: Here, you’ll need to have a home requiring substantial renovations in order to gain approval. These loans are eventually folded into a mortgage when the renovation work is complete. A lot of people buying fixer-uppers look toward these types of loans.
There Are also Builder-Centric Construction Loans
Builders have a couple of extra options when it comes to construction loans. These two are the ones most commonly sought after.
- Owner-Builder Construction Loans: Every now and then, a builder is going to build his own house — and why wouldn’t they? So long as the builder has the certification to prove that the house they are building is in fact their home, they can apply for this specialized loan.
- End Loan: This loan is designed for the builder-investor. An end loan works by a builder taking on the costs of construction a new home. Once the home is complete, a buyer will get a mortgage to pay the builder for the home.
Qualifying for a Construction Loan
It’s more difficult to qualify for a construction loan than it is for a for a traditional mortgage. Because there is not a complete home to be used as collateral, your lender is assuming more risk — like we said earlier, this loan is based on a projected value of the home being built. As a result, the lender is going to want a highly detailed list of information about the home: its size, its location, its materials, who the contractors are, etc.
And after all of that, a lender must feel assured that the borrower is capable of making their monthly loan payments — not just after the fact, but during the construction phase. There are several criteria traditional lenders will take into account regarding your qualifications for a construction loan:
- Credit Score: It’s common for traditional lenders to require a credit score of at least 680 to be considered as a candidate for a construction loan.
- Debt-To-Income Ration: A traditional lender is generally going to look for your total debts to be no more than 45 percent of your income. And of course, a lower percentage is a better percentage.
- Down Payment: Most traditional lenders will require a 20–30 percent down payment for new construction, though some renovation loans may allow for less.
- Repayment Program: When it comes to construction-only loans, a lender is going to want to know if you plan on paying the loan balance in cash, or if you plan on refinancing upon project completion.
Getting a Construction Loan with Hard Money Lenders
A hard money construction loan is frequently used to finance residential or commercial new construction projects. If you can’t get construction funding through a traditional lender, or simply want speed and flexibility, a hard money lender might be right for you. While a hard money construction loan will still require detailed information for approval, the upfront capital needed and payment options are often more convenient for investors.
Typical hard money construction loans run for six months to two years, require interest-only payments (that are often bundled into the loan itself), and are funded in installments that follow a predetermined schedule of milestones. Construction loans are repaid when the work is complete and the property is sold or refinanced.
A Few Final Considerations for Construction Loans
Even the best construction plans can go wrong sometimes, so there’s a few more things to take into consideration before going after a construction loan. One thing you’ll want to make sure you have is adequate savings. Unexpected costs are not as unexpected as you might think, and your lender will want to know that you can afford them if they arise.
There are going to be frequent, ongoing inspections as portions of the work are completed. Because lenders pay the build in stages, or draws, the lender is going to conduct routine inspections to make sure everything is going according to plan.
Get Informed, and Get Building
Construction loans aren’t the most complicated property lending out there, but they can be difficult to secure. Make sure you thoroughly research all of your possibilities before deciding which loan is right for you. Pretty soon, you’ll be able to watch your investment come together from the ground up.