Construction Loans: What Are They And How Do They Work?
If you’ve been going from open house to open house and not finding anything you like, you might decide it’s time to build the home you want yourself.
While building a new home can be a bit on the expensive side, it’s not completely out of reach, especially if you get a loan to finance the process. Post-construction, you can refinance the loan and find a mortgage that works for you. Let’s see which construction loans could help you if you’re thinking of building a house.
Table of Contents:
What Is A Construction Loan?
A home construction loan is a short-term loan with higher interest that’s used to cover the costs of building a home. Once the funds from the construction loan have been used and the house has been built, this type of loan is typically converted or refinanced into a standard long-term mortgage loan.
If you want to build a brand-new house from the ground up but don’t have the funds to do so out of pocket, a construction loan will likely be your best option.
Construction loans are short-term loans, so funds are typically available for a year or so while construction is being completed. After that, you’ll need to have the loan converted into a mortgage loan or pay it off by other means.
Key takeaway: A construction loan is similar to a mortgage, but it covers the cost of building a home instead of purchasing one.
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Generally, construction loans won’t go to the borrower; instead, the funds go directly to the builder or general contractor as needed. These funds can be used for all the costs related to the project, including:
- Permit costs
- Construction materials
Construction loan funds are only available during the building phase of your home. Unfortunately, these funds can’t be used to furnish or decorate your home once it’s built.
How To Get A Construction Loan
Key takeaway: The construction loan application process is similar to a mortgage, but you’ll need to provide a construction plan and projected costs.
Before you can get a construction loan, you need a plan for your future house.
The approval process for a construction loan is similar to a typical home mortgage, but you’ll have to show the lender detailed plans for the project, including cost estimates. The lender may also need to approve of the company that’s building your home.
You won’t be approved for a construction loan until you have all these details sorted out. However, you may want to start having conversations with potential lenders before you begin the planning process. This gives you the flexibility to shop around for different lenders so you can get a better idea of how much you’ll likely be able to borrow.
Key takeaway: Payments from a construction loan come in a series of disbursements called draws on a schedule set by your lender.
Once you’ve got your plan and your loan approval and you’re preparing to break ground, your builder will receive the first disbursement of the funds.
With construction loans, the money doesn’t come in one large lump sum. Instead, the builder receives a series of disbursements called draws. Whenever your builder requests a new draw for the next stage of work, an inspector will come to the site and check out the progress on behalf of the lender.
Before you break ground, be sure both you and your builder understand the lender’s draw schedule, including when and how disbursements are made.
During building, you can typically make interest-only payments on the loan, and you’ll only be charged interest on the amount that’s been disbursed.
Types Of Construction Loans
As you shop around for loans, you’ll need to decide which type of loan makes the most sense for you. A few different types of construction loans are available, each with its own pros, cons and requirements. Let’s take a look.
Types of Construction Loans
Converts to a permanent mortgage once the building is completed
Only covers the cost of construction
Covers the cost to renovate a home
Covers construction costs when the owner plans on completing construction themself
Best for: Simplifying paying for a home start to finish
A construction-to-permanent loan is a construction loan that converts to a permanent mortgage once the building is completed.
With this type of loan, all of your financing is rolled into a single transaction, meaning you’ll only have to complete one application and go through one closing process. This can make financing your home simpler and potentially cheaper, as you’ll only be paying closing costs on one loan.
Additionally, with a construction-to-permanent loan, you don’t have to worry about not being able to obtain financing for a mortgage once your home is completed. Once you have your approval for the loan, you won’t need to go through the approval process again. The loan will simply convert into a permanent loan when construction is completed.
Best for: Shopping around for the best deal on your mortgage
A construction-only loan is exactly what it sounds like: You’re receiving the funds to cover only the cost of construction. After that, you’ll need to get another separate loan to refinance the construction loan into a mortgage.
With these types of loans, you’ll go through two separate application processes and two separate closings. This can mean extra documentation and paperwork, and possibly higher closing costs.
The main benefit of these types of construction loans is that they give you the freedom to shop around for your mortgage. When you get a construction-to-permanent loan, you’re limited to whatever rates and terms are offered by the construction loan lender. Construction-only loans allow you to find the mortgage that’s best for you.
Best for: House flippers or renovators
If, instead of building a brand-new house, you want to buy a fixer-upper home to renovate and rehab, there are loans available for this, too.
A 203(k) loan is one such type of loan. It’s insured by the FHA and gives home buyers the funds to purchase a home plus money to complete needed renovations. Rocket Mortgage® doesn’t offer 203(k) loans. Conventional loan borrowers also have options for these types of loans with Fannie Mae’s HomeStyle® Renovation loan and Freddie Mac’s CHOICERenovation℠ mortgage.
Homeowners who want to fix up the home they currently live in can also refinance with one of these renovation mortgages.
If you don’t need a whole mortgage but just enough cash to pay for repairs or renovations, you may consider tapping into your equity with a home equity loan, home equity line of credit (HELOC) or cash-out refinance.
Rocket Mortgage doesn't currently offer HELOCS but does offer home equity loans and cash-out refinances.
Owner-Builder Construction Loan
Best for: Homeowners with a professional background in construction
Owner-builder construction loans are aimed at individuals who wish to be their own general contractor instead of hiring a builder to manage the process and all the subcontractors involved. While acting as your own general contractor can save you money, this option is typically only available to those who have proven experience as a home builder or are licensed to oversee these types of projects.
Your interest rate on a construction loan will depend in part on the type of loan you get. Construction-to-permanent loan rates are typically more in line with standard mortgage rates, while construction-only loan rates might be slightly higher.
A 20% down payment is typical for construction loans. Conventional mortgage lenders customarily like to see a credit score of at least 620 and a debt-to-income (DTI) ratio below 45%, but individual construction loan lenders may have more stringent requirements.
You’ll go through the typical process you would with a regular mortgage. You’ll be asked to provide your credit score and documentation like tax returns, W-2s and bank statements that demonstrate your ability to afford the loan.
The construction loan lender may also require that you have a certain amount of cash set aside in case building costs end up being higher than expected.
Need extra cash for home improvement?
Is a construction loan harder to get than a mortgage?
Construction loans are typically harder to qualify for than a mortgage. This is because mortgages are backed by the home itself as collateral. Because there is no home yet with a construction loan, the expectations for the borrower are higher.
What do I need to get a construction loan?
A construction loan has the same requirements as a mortgage, but you’ll also need to provide plans and projected costs for your home’s construction.
What happens if I don’t use all of my construction loan?
If you don’t use all of the construction loan, the remaining balance is either directly refunded to you or taken off your balance. While you can’t use the construction loan on furniture or decor, you can use it on landscaping, appliances or other permanent fixtures.
The Bottom Line
Building a house can seem overwhelming, but construction loans can relieve some of the stress. Make sure to reach out to different lenders and shop around for the best rates when looking for construction loans.
While Rocket Mortgage doesn’t offer construction loans, we can help refinance your construction loan into a regular mortgage once the building is complete.
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