Navigating Construction Loans

You’ve shopped around and just haven’t found the home of your dreams. So, you instead look into buying land and building your own home—a great way to create the exact house for your needs. Before you start writing checks, you should consider how you'll fund the project, and understand how construction loans work.

Construction loans are set up differently than traditional home loans. That’s because the bank is taking a risk is funding your project. After all, if you default at some point during the build, all they really have is the land value in order to recoup their loss. Without a structure, the bank isn’t going to give you a traditional loan either, because they won’t have the asset to counterbalance their investment.

Loan Structure

A construction loan is intended to be a short-term loan solely for the purpose of paying for supplies and labor to build the home. A quick build is better in the bank’s mind, since they want to secure their investment as soon as possible. That means the longer your build continues, the more the loan is going to cost you, so it’s important to have realistic goals and keep your project on it’s planned timeline.

Getting a Loan

Construction loans are more difficult to qualify for than traditional loans. To get approved, you'll need a detailed timeline, budget, and design plan. You'll need to prove a steady income, and have an impressive credit score, plus a low debt-to-income ratio. Shop around with the local banks, online, and at credit unions. Not all banks offer these types of loans.

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Risk on Both Sides

The bank is taking a risk, and you are too. Construction loans are typically set up for six months to one year. During that time, the rate will vary in association with the prime rate. That means the bank can’t just randomly pick rates, but you’re taking a hit if prime starts climbing. During the course of construction, the bank pays out chunks of money in stages rather than providing a lump sum up front. This is also based on that plan you’ve got all laid out.

Payments

Construction loans are partially deferred during construction, meaning you typically only pay the interest portion during the build. While it’s nice to have the lower payment during construction, it means that you're not paying down the loan the entire time you’re building. Your payments are simply to keep the loan amount from growing due to interest.

Bank Involvement

Taking a construction loan also means the bank has a very involved interest in your project. In fact, it is common for the bank to order an inspection of sorts with each loan payment. This means that you can expect a bank representative to pop up at the construction site periodically.

Loan Types

Although similar, there are two main types of construction loans, each with their pros and cons.

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Construction-to-Permanent Loan

This type of loan accounts for both the building portion and the long-term home loan. Fees for construction are paid out as outlined above, and rates vary during the build. Once the home is complete, the loan rolls over into a traditional loan, and you can choose whether that's fixed or variable, and whether you want a 15 or 30 year term.

Because there's only one loan that changes from a temporary to a permanent loan, you'll only have one set of closing fees to pay. During construction, you'll pay interest only, and when the loan rolls over you'll add principal to your payments.

Construction-Only Loan

As suggested by the title, a construction-only loan funds only the building portion of the project. At completion, you take another loan to pay for the home. This option will cost you more in closing fees because you pay for two separate loans.

It can be a great option if you have money tied up in another property, because you'll have a reduced down payment over the construction-to-permanent loan. Once your primary property sells, you can put that money down on your permanent loan for a lower total loan amount and long-term lower payments. The risk, however, is that if your financial situation changes during construction, you may not qualify for the permanent loan.