A Home Builder’s Guide to Understand Construction Loans
Whether you’re building your dream home or developing real estate, you’ll need a construction loan. They offer the necessary funds and can convert to a traditional mortgage after construction. They can also be complicated. Here’s what you need to know to qualify for a construction loan.
What Is a Construction Loan?
A construction loan is a short-term loan that covers the cost of building a home. It typically has a set term and requires repayment within six to 24 months. Here are some of the different types of construction loans you’ll encounter:
CONSTRUCTION-TO-PERMANENT LOANS
A construction-to-permanent loan lets you borrow money to build a home. When you finish building, it converts to a permanent mortgage. The benefit is that you only have to pay closing costs once.
CONSTRUCTION-ONLY LOANS
You receive funds to complete the property. After paying any closing costs and fees, you reapply for a new loan to pay off the loan. This arrangement is ideal for expensive homes, though, the two separate transactions make construction-only loans pricier than their counterparts.
RENOVATION LOANS
Renovation loans are for “fixer-uppers.” They come in several flavors, such as cash-out refinance and home equity line of credit (HELOC). You can combine the construction and renovation costs into the final mortgage. You also do not need to present your lender with an exhaustive plan or budget.
OWNER-BUILDER CONSTRUCTION LOANS
Owner-builder construction loans let the borrower act as the home builder. These are uncommon because most people are not qualified home builders. Your best chance of getting one is to be a licensed builder or contractor.
END LOANS
End loans are synonymous with mortgages. It is a long-term loan that pays off short-term construction. Some end loans have interest-only features, which delay the repayment of the principal.
How a Construction Loan Works
A construction loan starts as a short-term loan. It covers construction from start to finish. That includes permits, labor, framing, building materials, and more. Afterward, the borrower enters into a permanent loan.
Qualifying for a construction loan is similar to obtaining a mortgage, but you have to jump through more hoops. Lenders are often leery of construction loans, in part, because the final product doesn’t exist, yet. If something goes wrong, they’re on the hook. It is why construction loans have higher interest rates than other types of loans.
Terms and conditions vary between loans. When you qualify for a United construction loan, you get 80 percent of the financing for construction. You have a year to build and only have to pay interest until the home is officially occupied.
Meet with Your Lender
Construction loans require a lot of time and research. Builders estimate construction takes 10 to 16 months for custom homes. That doesn’t include the month or two for creating blueprints or the time scouting locations.
Realistically, you’ll spend two years building your dream house from concept to fruition. To make sure it only takes two years, you’ll want to present your lender with a bulletproof plan. This plan is also your lender’s chance to review the soundness of the investment.
Here’s what you can expect when you sit down with your lender:
A CREDIT HISTORY PULL
A high credit score, low debts, and reliable income are must-haves to get a construction loan. While there is no hard cut-off for your credit score, yours should be 680 or higher. Your lender will also check the credit and credentials of your builder.
REVIEW THE BLUEPRINT
Lenders want to know everything. That includes details about the floor plans, construction materials, timeline, location, and the builder, just to name a few. Builders typically have all this information in a “blue book” for easy sharing.
TALK WITH AN APPRAISER
The loan size depends on the value of the finished home. An appraiser considers the blue book and the building specifications before relaying an estimate to the lender. The appraiser also factors in the home location, current housing market, and the price of other homes like yours.
DETERMINE THE DOWN PAYMENT
The rule of thumb is that borrowers put down a 20 percent down payment. Some lenders may require 25 percent. The sizeable down payment forces borrowers to have significant equity in the project. The investment keeps borrowers from walking away in case something does go awry.
Find a Qualified Builder
Your choice of builder is critical when qualifying for a construction loan. A qualified builder is a licensed general contractor with a strong reputation and track record. You should obtain a list of their current and past projects, profits and losses, and licenses. You’ll also need a line-by-line estimate of all the construction costs, including parts and labor.
Do your research before settling on a builder. Check with the Better Business Bureaus or your state attorney general’s office for reviews, complaints, and lawsuits. Doing your homework mitigates the chance of hiring an unscrupulous builder or contractor.
Note that you can be your own general contractor or build your home by-hand.
What If I Don’t Get Approved?
If you’re denied for a construction loan, you probably have financial red flags. Late payments, unresolved debts, and a low credit score are just a few causes for concern. Lenders are also wary of approving loans if you recently changed jobs or have erroneous application information.
While rejection stings, it is constructive criticism. Most lenders include some version of the five C’s of credit: character, capacity, capital, collateral, and conditions. For instance, if your capital is inadequate for the loan size, try downsizing or choosing a more affordable location. If you have a low credit score, focus on making on-time payments and eliminating debt.
Not sure where you went wrong? Ask United. Our loan experts will show you where you can improve, so you return with the necessary qualifications next time.
The Bottom Line
A construction loan is a useful tool to build your dream home. You should consider a construction loan only if you have the financial cushion to soften any financial setbacks. Do your research and make sure the terms work for you.
