Definition of a Home Building Loan
As the name suggests, home building loans or construction loans help people construct their dream homes. They can also help with home renovation projects.
These loans differ from traditional mortgages in their terms and approval process. A home building loan is generally a shorter term than a conventional mortgage loan used to purchase a resale property.
The interest rates also tend to be higher. There is quite a bit to know about construction loans. We’ll take a deep dive into what differentiates house building loans from typical mortgages and how they can help achieve your goals.
How Construction Loans Work
New construction loans can be categorized in two main ways, namely qualification and loan disbursement. Let’s look at some of the vital details before taking out a construction loan.
It is essential to note that in order to get this type of financing, you’ll need to go through a similar mortgage approval process as you would with a resale property.
Lenders will want to know you have a good credit score, check your employment, and verify you have adequate income to support the loan.
The property will also need to have a real estate appraisal completed by a professional appraisal company to ensure fair value.
Collateral, Architectural Plans, and Builder Requirements
When you take out a new construction loan to build a home, you aren’t required to have collateral, as with a traditional mortgage loan. This makes the loans less stressful.
However, borrowers must meet some requirements before loans are approved and disbursed. Generally, architectural plans must be inspected as well as the builder in question and a borrower’s finances.
Loan Disbursement is Different Than A Traditional Home Mortgage
A home construction loan is also disbursed differently. Instead of traditional loan disbursement, which involves transferring a lumpsum amount at the closing to a borrower, lenders will disburse money in installments (known as draws).
Each installment coincides with a vital construction phase. For example, when the foundation is poured, a designated bank inspector will make sure the work has been completed.
When the framing is done, they will do the same. A banking representative will look over each of the significant phases in construction before funds can be released to either the builder or homeowner.
The amount paid is also based on the completed work stated in the construction inspection report.
Types of Home Building/Construction Loans
Here are 3 types of home building loans to help you understand the best one for you.
I. Construction-Only Loans
This type must be repaid entirely after the home building process is complete. You must qualify and pay closing costs after getting approved to get a construction-only loan.
A construction-only loan is perfect when you have a sizable cash reserve or want a permanent lender during the building phase.
II. Renovation Construction Loans
As the name suggests, this type is taken for renovation purposes. Home renovations can be costly. The cost is wrapped into a mortgage loan with a renovation construction loan instead of being financed after closing.
Renovation construction loans usually vary based on the home value after renovation is complete. These loans should be taken by persons who don’t have adequate cash for renovations.
III. Construction-to-Permanent Loans
This type of construction loan converts to permanent mortgages when home construction is completed. They have a locked interest rate at closing and work perfectly if the construction plan is known and borrowers are keen on predictable interest rates.
Most buyers who are building their own homes will look to get this kind of financing.
Construction Loan Coverage
While home constructions differ in scope, construction loans generally cover the cost for land, permits, plans, labor and materials, additional costs (if the projected costs are estimates), and interest reserves if you don’t wish to pay interest during building.
Getting a Construction Loan
Like mortgages, you need to meet some requirements. Most importantly, it would help if you had a credit score that falls above a specific range. You also need to have a suitable debt-to-income ratio. Down payment may be required. However, this varies based on the lender in question.
Ideally, your debt shouldn’t be more than 0.45 of your income. Most home building loan lenders require a 680-credit score or higher. Most lenders need a 20-30% down payment for a new construction loan. Requirements vary depending on the lender.
Choose a Home Construction Loan Lender
It would be best to focus on mortgage lenders who offer construction loans. What’s more, they need to have favorable rates and terms. It also helps to establish if you can secure a loan with your current credit score.
Since home construction can be lengthy, financing should be selected with care. Focus on lenders who manage the expectations of borrowers and builders perfectly. Experience is critical when choosing a construction lender as such lenders will guide borrowers with minimal frustration.
Experienced lenders also understand borrower needs and have crafted streamlined processes. If you qualify for a loan from such lenders, you can rest assured it will be affordable and have other favorable terms.
Final Thoughts
When you want to purchase a piece of land and wish to build the home simultaneously, a construction loan will be your best option. Hopefully, you now have a much better understanding of how construction loans work—best of luck with your new construction project.
This article was submitted by an external contributor and may not represent the views and opinions of Benzinga.