How Do Construction Loans Work?

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At their most basic level, construction loans offer short-term financing for individuals or companies that are building homes. These loans often come with terms of up to 1 year, with variable rates and stringent approval requirements that include having a detailed construction timetable and plan along with a solid budget. Borrowers may also pursue construction-to-permanent loans, which take the balance of the construction loan and roll it into a traditional mortgage once the builder issues a certificate of occupancy.

As is the case with traditional mortgages, the key to making this type of loan financially feasible is to find a construction loan with monthly payments that work with your budget. This becomes increasingly important if you’re making rent or mortgage payments to live somewhere while your home is under construction.

Using a construction loan calculator can help give you a ballpark estimate of what to expect in terms of payments, and learning more about this type of loan can help prepare you further should you choose to pursue this option from a lender.

Potential Risks

These loans provide a way for you to afford the cost of home construction without relying on a mortgage, which many banks won’t provide for a home that doesn’t exist. Some of the potential risks involved include:

  • The finished home’s worth equaling less than the amount that the construction costs, which can happen in a volatile housing market or if the builder does sub-par work
  • The home not being ready on budget or on time, which could leave you on the hook for paying two mortgages or a mortgage and extra payments for rental accommodations
  • Your inability to get a final mortgage if your credit or income changes dramatically during the construction phase

Because of the increased risk to you, many experts recommend having a financial cushion in place in case the construction process goes longer than expected or meets with unexpected budget issues. Likewise, because these loans put lenders at increased risk since there is no brick-and-mortar collateral, the interest rates are normally higher than those of traditional home loans.

Construction Loan Rates

Construction loans usually come with variable interest rates set to a certain percentage over the prime interest rate. For example, if the prime rate is 2.5% and your loan rate is prime-plus-2, then your interest rate would be 4.5%. If the prime rate changes during the life of your loan, your interest rate also adjusts.

For example, if the prime rate goes up to 5%, your new interest rate would be 7% with that same prime-plus-2 interest rate on the loan. In some cases, lenders may offer a fixed rate loan in exchange if you meet additional requirements, such as if you pay 20% down or pay increased closing costs and fees.

In many instances, construction loans are structured as interest-only loans that allow you to pay interest only on the money that you have borrowed up to that point. For example, if John has a $200,000 construction loan, but the bank has paid out just $20,000 to him so far, he only pays interest on the $20,000, not the full $200,000. This keeps the initial payments low, and payments slowly increase as more money is paid out during the construction process.

Rates and terms vary depending on the lender, your creditworthiness and the type of construction loan you get. In addition to new construction loans, you can also pursue specialty loans such as FHA construction loans and VA construction loans.

FHA Construction Loan

A loan backed by the Federal Housing Authority (FHA) offers several benefits over a traditional construction loan. You can choose from two different types of FHA construction loans, including a Construction-Permanent mortgage for a home built from scratch, or a 203K Rehab mortgage for a home that needs repairs or rebuilding. Both types of loans bundle the construction and purchase costs into a single mortgage instead of a separate, short-term loan. Benefits of these loans include:

  • Borrowers with credit scores as low as 620 can qualify
  • Borrowers with debt-to-income ratios as high as 50% can qualify
  • 3.5% down payments
  • Up-front closing means that borrowers don’t have to re-qualify at the end of construction

Some of the limitations of an FHA construction loan include:

  • Maximum loan amount of $417,000, which means construction costs that exceed that amount require higher down payments
  • Shortened construction times of 150 days or less

VA Construction Loans

Although it can be challenging to find a construction loan from Veterans Affairs (VA)-approved lenders, the benefits make it well worth the search for veterans and military families. VA loans are backed by the U.S. Department of Veterans Affairs, but each lender sets the terms for these loans. In many cases, qualified borrowers can use their VA entitlement to secure a mortgage on new construction, which eliminates the need for a down payment. VA construction loans are few and far between, but many lenders allow veterans to use VA entitlement in the permanent phase of the construction process in place of the construction loan.

How to Get a Construction Loan

To secure a construction loan, you need to find a lender that offers these specialized loans. Research various options to find the bank or lender with the most competitive rates and terms. Look for a lender that offers single closing when construction starts, interest-only payments during the early phases of construction and flexible options regarding the construction loan down payment necessary to obtain the loan.

To get started, you must provide the lender with basic information about all of your debts, income and assets. Lenders look at your credit score and credit report, along with the purchase contract and signed construction contract for the future home, to decide whether or not to approve your loan.

The Bottom Line

As long as you know all the risks and costs upfront, taking on a construction loan can be a smart option to put you on the road to building your dream house. Ideally, you should have a financial cushion in place to help offset potential expenses during the process. When shopping for a loan, secure terms that work well for you.

Some construction loans offer a short-term solution that you must pay in full once construction on your home is completed. In this case, you need to get a traditional mortgage to cover the costs. Construction-to-permanent loans offer a better alternative because they roll right into a fixed rate mortgage after the construction phase.

Caryn Anderson
Caryn Anderson combines extensive behind-the-scenes writing experience with her passion for all things food, fashion and finance. Anderson honed her craft while earning her B.S in Communication Studies from New York University.

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