A Construction loan is a type of loan used to cover the expenses of constructing a home, these loans are generally one year fixed term and are designed to provide you with enough time to build your house. When the construction of the home is complete you generally will need to get an additional loan to pay off the outstanding debt, this is referred to as an “end loan”. This means you must refinance at the end of the term and enter into a brand new loan or mortgage, to finance your newly built home.
Qualifying for a Construction Loan?
The process of qualifying for a Construction Loan is more complex then applying for a traditional loan or mortgage. The reason being is that lenders must take on more risk when dealing with this type of loan because many things can go wrong. The loan is given to a builder in which the lender feel’s confident that the project to be constructed will have a certain value when it is complete. An example of something that can go wrong would be the builder doing a poor job executing the construction and the value of the property failing to meet the expectation of the lender. This would turn out to be a bad investment for the lender, as the property would not be worth as much as the loan. Due to the high risk of these types of loans there are strict qualifying procedures put in to play as an insurance policy for these lenders. Here is what is required when qualifying for a construction loan:
- A Licensed General Contract Is Needed. This licensed contractor would be a qualified and would have an established reputation for building quality homes or buildings. This can create some serious challenges for receiving financing for your build if you plan on executing the project as your own general contractor or if you happen to be involved in a owner/builder situation.
- Detailed Specifications Need to be provided to the Lender. This is usually called a “blue book”, which generally includes everything and anything included with building the project such as floor plans, ceiling heights, and types of materials used in the build
- An Appraiser Must provides an estimate of the home’s value. It may come across as challenging to appraise something that has not yet been built, but a qualified appraiser would use the blue book and house specs in conjunction with the land’s value to determine an estimate of the overall value of the property and future home. When these estimates have been completed, their calculations are then compared to similar houses with comparable features and located in similar. These houses are called “comps the appraiser will use these comps to give an estimate of the homes value.
- A Construction Loan Requires a Large Down Payment. In most cases, 20% is the minimum lenders will require you to have upfront for a construction loan – some lenders can even require as much as 25% down! This acts as an insurance policy for the lender in 2 ways. First, it guarantees that you will be invested in completing the project and will not bail if something goes wrong. Second, this helps cover the loss if the property value does not turn out to be what the lender expected.
If you are looking for a construction loan and you met all of these criteria and have good credit, you should have no trouble qualifying for a construction loan. There are generally other requirements that lenders ask for with any loan, and these requirements are regarding your income; this is to ensure you can afford the mortgage payments. Also your current home value can be required and would generally give the lender much less risk and would typically give you a lower interest rate.
How Construction Loans Work?
Upon approval a qualified borrower would begin receiving the construction loan at an agreed amount through the lender. The money however is not given to the builder in one lump sum; it is given over a set period of time. This is organized into schedules known as “Draw’s”.
What Are Draws?
Draws are organized into intervals that give the borrower access to the construction loan throughout the lifespan of the project. There can be multiple draws that are set in place throughout the build. An Example of how draws can be organized would be as such: Upon approval of the loan the builder would receive 10% of the total loan, after the property has been cleared and the foundation has been poured an additional 10% of the loan would be given. The next payout could be after the house has been framed, and the next consecutive payment after the roof is up and sealed.
The draws are organized based on negotiations between the builder, the borrower and the lender. Generally, the down payment would be considered the first draw, this is to put the risk on the buyer and not the lender. To ensure the build is going as planned, the lender can require an inspection at each draw before giving the money to the borrower. This ensures that the project keeps on track, and the money is being spent the way that it should be.
When the final draw has been paid out and the house is finished, the borrower would need to get a “end loan” in order to consolidate the construction loan.
Construction Loan Rates?
As you know with any type of loan there are interest rates involved. Construction loans are usually set up as variable rate loans, with the rate set at a “spread” to the prime rate. What this means is that the interest rate is equivalent to a certain amount plus prime. For example, If the Prime Rate is 2% and your rate is prime-plus-one, then your total interest rate would be 3% which would adjust as the prime rate fluctuates.
Generally, construction loans are set up as interest-only loans. This makes payments more feasible as it means you only pay interest on the money you have borrowed instead of paying down any part of the principle loan balance.
You are only charged interest on the money in which you have received. For example, if the total loan is $200,000 and only the first $20,000 has been received, you would only pay interest on the first $20,000. You will be required to make monthly payments on this loan. As the borrower is given more of the total loan their monthly payments would grow accordingly.
Things to consider when getting a Construction Loan?
Construction loans give you the ability to build a home you would otherwise not be able to. A lot of benefits can come from building your home as it gives you the ability to custom tailor the house to what you and your family’s needs are. There are some risks to building your own home with a construction loan in comparison to just buying a home.
Here are some of the risks:
- The House isn’t completed on schedule. This would result in additional costs for rental accommodation. The final payment on your construction loan will become due, if the project is not completed the will be a fee to extend that loan until the house is finished and you are able to refinance into an end loan.
- Upon Completion the house value is not worth as much as the cost of the build. If the housing market crashes or the builder does a poor job you could find yourself needing to come up with extra cash at the time the end loan would begin.
- You could no longer qualify for the end loan. If drastic changes occur in your income or credit this could affect whether or not you qualify for the end loan. The balance needs to be paid off when the loan ends. If you cannot make the payments, you could end up losing the new home to foreclosure.