Many people dream of building the house of their dreams, either from the ground up or by renovating an existing house. Some look at home building plans or plots of lands and imagine their perfect home nestled into the location. Others look at dilapidated or outdated homes and see the beauty in their bones. They just know they can turn that old house into a beautiful home.
These dreams don’t need to remain dreams, however. With construction financing, dreams can become reality. The financing process is different from a traditional loan and requires more steps.
Lenders have certain requirements and methods of disbursement specific to construction loans. For those who truly want to take their dreams out of their imagination and make them real, construction financing is the path home.
What Is Construction Financing?
Many people are familiar with traditional mortgage loans. A person purchases a pre-built home. The bank pays for the home, and the person is responsible for repaying the bank plus interest for the purchase. When they finish paying the bank, they own the house outright.
Construction loans, sometimes called “Self-Build Loans” or “Builder Loans,” are very different. With construction loans, you finance the construction or renovation of a home. The term of the loan is much shorter than a standard loan.
The loans cover the time during construction, generally for a year or less. The funds from the loan may only be used to cover the construction of the house, not furnishings or other removable items.
How Does Construction Financing Work?
Construction loans are more complicated than a standard mortgage, so lenders require more documentation and involvement in the process. Borrowers must prepare plans and acquire estimates for the cost of the project.
The payout plan is one of the biggest differences between construction loans versus standard loans. With construction loans, funds are disbursed in “draws,” or incremental amounts. These draws are coordinated with different phases of the building process.
For instance, if a buyer has been approved for a loan to buy land and build a new home, the first disbursement may be made at the time of purchase of the land. Another disbursement may be made at the time the foundation of the home is dug and poured, and yet another may come after the house is framed.
Unless the buyer’s contractor requires payment that differs from the bank’s schedule, the payments are made directly to the builder. If the payment schedule is different, the buyer may need to pay the contractor and then be reimbursed by the bank. This is something the buyer will work out with the contractor before building commences.
Building a home comes with higher risks than purchasing a live-in-ready home. To protect themselves, banks only issue payments upon progress and charge a higher interest rate on the loan. After all, if the buyer stops building and abandons the project, the bank is stuck with a half-built home.
To aid buyers in the financing process, banks only charge interest on the loan until the end of the loan term. At that point, the buyer is expected to repay the loan. They do this by either refinancing the construction loan or obtaining a standard mortgage on the finished project, something which may be an option when designing the construction loan.
Types of Construction Loans
There are three basic types of construction loans.
Stand Alone or Construction Only Loan
Just as it sounds, a construction only loan is only for the cost of building the home. It covers both hard costs (costs of construction) and soft costs (costs of architects and things like city permits). After the build is completed, the buyer obtains a new mortgage for the completed property and uses part of it to pay off the construction loan.
Construction only loans are beneficial when a buyer may not have enough money to put down for a mortgage. Since they only need to pay the interest for the construction loan, they’re able to save more funds while searching for a lender who will work with them for the final mortgage. This can be risky, however. If the market is changing, loan interest rates may change as well. Rates may go down, but the buyer also runs the risk of them going up. Rather than run the risk of paying more money for higher interest, buyers may want to explore a different construction loan option.
Construction to Permanent Loan
Construction to permanent loans streamline the lending process. Construction to permanent loans first work as a construction loan by paying for the building process in incremental draws. After the home is complete, the loan converts to a traditional mortgage, freeing the buyer from the tedious process of finding another loan and saving them extra closing costs.
This type of loan takes more money upfront, so it may not be an option for everyone. It does have the potential money saving advantage of locking in the interest rate available at the time of the construction loan. If interest rates go up, the buyer is unaffected. If they go down, the buyer always has the option of refinancing to take advantage of new, lower rates.
Sometimes a buyer doesn’t want to build; they want to renovate an existing home. They may already own the basis for their dream home or a planned purchase. This dream still requires costly remodeling, however.
These loans vary. In some cases, the buyer may not be required to make payments on the loan if renovation makes the home uninhabitable. The renovation loan is based on the projected value of the home after renovation.
Generally speaking, lenders are involved in the initial loan process. Unlike other construction loans, they require less to no oversight after granting the loan. The homeowner is responsible for managing the process and issuing payments to contractors.
Requirements for Construction Loans
Due to the high risk of construction loans, lenders have more approval requirements. Buyers must present their project plans along with estimates for the necessary work along with a construction schedule. Involved construction companies and contractors must be licensed and reputable.
For buyers with problematic credit, it is possible to obtain an FHA loan. This can be difficult, however. In most cases, buyers need to have a minimum credit score of 680 to be considered.
They must be able to put down at least 20% – 25% down on the project and be prepared to cover extra costs and fees as necessary. Lenders also check to ensure the buyer has a stable income and an acceptable debt-to-income ratio.
The buyer needs to have a plan for construction loan repayment. This may be a traditional mortgage if the buyer is planning on living in the newly-constructed or renovated property. Other buyers may have plans to sell the property immediately after construction.
Those buyers may seek a different type of end loan to repay the construction loan prior to the sale. Either solution is acceptable as long as the loan can be repaid on time.
The Dream Home Realized
It’s been said that when it comes to your dreams, every risk is worth it. With construction financing, buyers have the opportunity to live in the home of their dreams. There are risks and a lot of hard work involved, but the results are often worth it to buyers when they step into a space they’ve designed especially for themselves and their families.