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If you’ve been house hunting and can’t find the perfect home, you may decide to have one built for you.
This is becoming common as “housing inventory has been sitting around record lows,” says Andrina Valdes, CEO at Temul Capital in Texas. “More homebuyers are opting to build when they can’t find a good selection of homes in their area.”
A home construction loan can cover the cost of the land and the home. You have two options: Take out a loan that covers construction and eventually obtain a mortgage, or get a loan that only pays for construction.
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The process for getting a home construction loan is similar to the one for a standard mortgage, except that the lender will also need to vet the builder. Here’s what you need to know about how to get a construction loan for a home.
What Are the Different Types of Home Construction Loans?
Buyers can choose between a single-close construction-to-permanent loan or a two-close, stand-alone construction loan.
The main difference: “A one-time-close construction loan allows you to secure both short-term construction and long-term financing together,” Valdes says, while “a two-time-close construction loan requires approval for two separate loans and two closings.”
Construction-to-permanent, or C2P, loan: It funds the land and the construction, and then the loan converts into a permanent mortgage once the construction is complete. This loan can be more expensive than a traditional mortgage because borrowers make interest-only payments during the construction phase. When the loan converts to a standard mortgage, the payments may be recast based on the time left on the loan term.
One advantage of a C2P loan is that the borrower only has to complete underwriting and closing once, which can save time and money. This loan offers another benefit during construction.
“If you lose your job, have a medical collection pop up on your credit or some other disqualifying factor, it would not affect the permanent loan, as it is already closed,” says Melinda Lou Hensley, real estate agent at Re/Max Elite and former mortgage loan officer.
You’ll also lock in a rate on the permanent loan, she says, “protecting against interest rate fluctuations during the construction phase.”
Stand-alone construction loan: This is a short-term loan that pays for building the home. During construction, the lender disburses funds to the builder based on the percentage of work completed, and the borrower pays interest on the withdrawals. Once the loan matures, usually within a year, the borrower must either pay it off or take out a new mortgage.
“The type of mortgage that you convert your loan to will depend on your eligibility and personal financial situation,” Valdes says. For example, she says, “to qualify for a VA one-time-close construction loan, you’ll need to be active duty, a veteran or a surviving spouse.”
One important caveat is that a stand-alone construction loan can be more expensive than a C2P loan if you will need a permanent mortgage. That’s because you’ll have two loan transactions with two sets of closing costs and you could pay a higher interest rate for the permanent loan.
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What Are the Qualification Requirements for Construction Loans?
If you want a home construction loan, the typical requirements are:
- A strong credit score. You may need a credit score of 700 for conventional loans, though some lenders may set more flexible standards. Credit score requirements may be lower for loans through the Federal Housing Administration, Department of Veterans Affairs and Department of Agriculture.
- A sizable down payment. Your down payment will vary by loan type. You may be able to put down 5% on a conventional mortgage, but a construction loan could call for at least 20% upfront. Also, ask your lender how to get a construction loan with no money down. Down payments for FHA loans start at 3.5%, and you might not need a down payment on USDA and VA loans.
- A reputable licensed builder. Your lender will check that the builder is reputable enough to pay suppliers and finish the construction project. The vetting process will involve your builder providing professional licenses, proof of insurance and vendor references detailing payment history. The lender will also review the builder’s credit rating and financial standing.
Generally, the bar is set higher for borrowers who want a construction loan instead of a traditional mortgage. That’s because the loan has no collateral – the home hasn’t been built yet – as with a traditional mortgage.
Construction loans “are viewed as risky in the eyes of a lender,” Valdes says. This means qualifying can be difficult, and your interest rate may be higher than on a traditional mortgage.
What’s the Process for Getting a Home Construction Loan?
A home-building loan is similar to a regular mortgage, but with a few more steps in the application process. How to get one:
Get preapproved for a home construction loan. Preapproval is the lender’s process of looking at details such as your income and credit score to determine how much you can borrow and your interest rate. Aim to get preapproved before approaching a builder because you’ll be able to establish a homebuying budget.
Contact a bank that offers home construction loans for a preapproval. You’ll give verbal permission to pull your credit and provide the lender copies of these documents:
- Recent pay stubs or proof of other income.
- W-2 forms from the previous two years.
- Tax returns from the previous two years.
- Bank statements from the last two to three months.
- Recent statements for other assets, such as brokerage or retirement accounts.
- Earning statement, if self-employed.
When you are preapproved, you usually receive a letter with an expiration date. Most preapprovals are good for 60 to 90 days.
Compare offers from licensed builders. Next, you’ll find a builder or developer that can build your home. Try asking your friends and family members for recommendations, or check out this directory from the National Association of Home Builders for suggestions.
After gathering estimates from a few companies and comparing offers, you will sign a construction contract with a builder or developer. Hang on to this document – you’ll need it when you later apply for the home-building loan.
Request multiple mortgage rate quotes. That way you can use them to compare repayment terms, interest rates and closing costs for each offer. Backing up a bit, the lenders you approach about home construction loans will ask you a few questions to find out which program you should consider.
If you want a conventional mortgage, you may qualify for a single- or double-close construction loan through Fannie Mae or Freddie Mac. Alternatively, FHA, VA and USDA programs offer single-close construction loans.
With a C2P loan, the permanent loan portion may have a term of 15 or 30 years. But you will start by choosing a loan term for the first phase: usually six, nine or 12 months.
“Take the longest term available,” Hensley suggests, “to have time in case weather or labor and material delays happen.”
Apply for the home construction loan. An underwriter will analyze your income, debt and credit history to determine whether you qualify, what your terms are and how much you can borrow.
The underwriter will evaluate:
- Your credit reports, pay stubs, W-2 forms, tax returns and bank statements.
- The signed construction contract with your builder or developer that includes an itemized budget and a construction timeline.
- The builder’s financial statements, licenses and insurance documents.
- The land survey showing where the house will be built.
- The title policy, if you have it, for the land when purchased.
How Are Home Construction Loans Different From Traditional Mortgages?
New home construction loans are unique because they pay for a professional to build your home and then potentially fund the mortgage you will pay off over time. This is different from a traditional mortgage, which pays a seller upfront for an already built home.
Construction loans are also different because:
Financing is a two-part process. A construction-to-permanent loan starts with a short-term loan, usually up to one year, that pays for construction and then shifts to a permanent mortgage. You can also opt for a construction-only loan but will need a separate 15- or 30-year mortgage, which means two closings.
Lenders impose stricter credit standards. Borrowers usually need a credit score of at least 700 for a conventional construction loan but could qualify for a conventional purchase mortgage with a score of 620. Standards are more flexible with FHA, USDA and VA loans.
Borrowers usually have to fork over larger down payments. Lenders may ask for 20% upfront, but a government-backed construction loan allows you to make a low down payment.
Borrowers also pay higher interest rates. With no collateral to back a construction loan, you could pay about 1 percentage point higher compared with a traditional mortgage. Construction loans also usually have variable rates that fluctuate with a benchmark rate, such as the Libor.
The lender vets the builder. With a construction loan, the lender wants to make sure the builder will finish the project according to plan. The builder will need to prove its financial stability and give the lender detailed plans, a construction timetable and a budget for your project.
The loan is not disbursed as a lump sum. Instead, “The lender parses out the money as the house is completed in draws,” Hensley says. “If a customer doesn’t already own their land, the first draw … will be used to purchase the land.”
You’ll need to start making interest-only payments on these disbursed funds after closing. “After a final inspection, your construction loan will be converted to a permanent loan,” Valdes says.
The payment shifts to a principal-and-interest payment that is amortized over the remaining loan term.
Inspections are frequent. Draws on funds will come as building progresses, with the lender inspecting work before another check is issued. The lender will arrange for an inspector to verify that relevant milestones have been reached.
You’ll also need to keep in touch with the builder and ask for paperwork updates. Note that if your builder fails to pay subcontractors, their legal recourse is against you, and you would need to sue the builder to recover losses.
Reviewed on Aug. 4, 2023: This article was published previously at an earlier date.