What Is Construction Loan and How Does It Work?

Mar 11, 2022

6

min read

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uying a home is the dream of many. There are several ways of buying and owning a home. You can buy a fully established new home, a second-hand home, or build your own.

Usually, people opt to buy an established home for convenience, but an established home is nowhere near your customized home. There are several benefits of building your own home as you can customize it according to your needs and preferences.

But, building a home can be expensive and comes with a hassle. However, you can opt for a construction loan to create your dream home hassle-free and at a low price.

This article has everything covered on a construction loan.

What Is A Construction Loan?

A construction loan allows borrowing money to build the home rather than buying an established one.

It varies from a standard mortgage as it allows you to draw money from the loan as needed throughout the building process, paying interest only on the amount you use.

Construction loans are usually short-term loans with comparatively high interest. The loan covers the cost associated with buying land to build the house.

What Does A Construction Loan Cover?

Cost of Land
Architectural plan and design fees
Permit fees
Construction materials
Contractor labor

How Do Construction Loans Work?

When you apply for a loan, you need to submit the land contract and the construction plans. The lenders will have a valuer estimate the property's value upon the completion, and your loan will be based on the land price plus building costs or estimated worth when it is completed.

If you're building an investment property, some lenders may consider potential rental revenue, which might help you borrow additional money.

Purchasing and building a house are two different things. You need a big lump sum of money while purchasing, whereas you would need installments of money when building a house.

Thus, unlike regular mortgage loans, the lender distributes the funds much more like installments over time. These are called the draws, which are paid on different phases of the home's construction.

These draws usually occur when key milestones are reached, such as when the foundation is set, or the home framing begins.

The main advantage of this loan is that the borrowers are responsible for paying interest on the funds taken up to that point until the house is completed.

However, it is essential to note that the lender has an appraiser or inspector assess the house at various construction phases during the building process.

Once the property finishes, the borrower may convert the construction loan to a standard mortgage, depending on the type of construction loan.

For example, Mr. A wants to build a house and applied for a $500,000 loan. The client has found land for $150,000 and estimates his construction cost would be $350,000.

Thus, he would apply for the loan, and the valuer would analyze the worth of the land and the potential price of the house once it is completed.

Suppose that Mr. A can borrow a $500,000 loan based on the valuation and lenders agreed to lend him the sum. However, Mr. A won't receive the entire amount at once. He would get it as installments.

Firstly, he will get $150,000 to purchase the land. There are steps when building the house, such as first the base should be constructed, and the finishing comes at last.

The funds are released accordingly. Mr. A would receive $350,000 in installments when he needs them while building his home.

Types Of Construction Loans

Construction to permanent loan

A construction to permanent loan allows you to convert your construction loan into a permanent mortgage after the property finishes and you move in.

The advantage of using the construction-to-permanent loan is that you only have to pay one set of closing charges which lowers your overall cost.

When the loan transitions from construction to permanent, it becomes a regular mortgage loan of 15 to 30 years.

After that, you need to make payments that include interest and principal. You can choose between a fixed-rate and an adjustable-rate mortgage as required.

Construction only loan

A construction-only loan provides the funding required for completing the home's construction. Still, the borrower is responsible for either paying the loan off at the end of the term (usually one year or less) or getting permanent financing.

The borrower is only liable for interest payments on the money borrowed from these construction loans, which are dispersed based on the percentage of the project completed.

Construction-only loans might be more expensive and risky in the long run as your financial status may worsen during the construction process.

If you lose your job or encounter any financial difficulty, you may not qualify for a mortgage in the future, and you may be unable to move into your new home.

Renovation loan

In cash-out refinancing, homeowners usually take out a new mortgage for a more considerable sum than their current loan to renovate their home.

In this loan, the lender does not often need to disclose how the homeowner intends to use the cash with the loan. The homeowner manages the budget, the plan, and the payments.

The homeowner can borrow the loan to renovate the house based on the value of the price after the renovation.

FHA Construction Loan

With poorer credit ratings and smaller down payments, borrowers may pursue an FHA construction loan. These loans need a 3.5 percent payment from the borrower.

You can put your land equity toward your down payment if you've already purchased the land on which your home will be built.

The FHA construction loan is a construction-to-permanent loan and doesn't need you to make any payments while the house is being built. During construction, the interest rate may be constant or variable.

Requirements For Construction Loan

Good credit score
Low debt to income ratio
Down payments
Construction plans
Repayment plan

How To Choose A Construction Loan Lender?

Choosing the appropriate lender is the most critical step in getting a construction loan. It is vital to select a lender that processes many construction loans and is familiar with their complexities.

A lender who has processed several construction loans will understand how the process should work, what can go wrong, and how to avoid issues.

Thus, they can assist you in ensuring that your construction is completed appropriately.

Here are some of our top lender suggestions for construction loans: